Capital Structure

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FINANCIAL

MANAGEMENT

CAPITAL STRUCTURE

Its meaning, patterns of capital

structure, theories of capital

structure, factors determining capital

structure, difference between capital

structure

structure and

and financial

financial structure

structure

SUBMITTED BY SUBMITTED BY

A!ES! C!A"#ER

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eaning of

Capital Structure

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apital Structure is referred to as the ratio of different -inds of securities raised b. a firm as long/term finance0 The capital structure in1ol1es two decisions/

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.pe of securities to be issued are e2uit. shares, preference shares and long term borrowings *#ebentures0

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elati1e ratio of securities can be determined b. process of capital gearing0 3n this basis, the companies are di1ided into two/

%0 !ighl. geared companies / Those companies whose proportion of e2uit. capitali4ation is small0

2. Low geared companies / Those companies whose e2uit. capital

dominates total capitali4ation0

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or instance / There are two companies A and )0 Total capitali4ation amounts to be I"R &'',''' in each case0 The ratio of e2uit. capital to total capitali4ation in compan. A is I"R 6',''', while in compan. ), ratio of e2uit. capital is I"R %6',''' to total capitali4ation, i0e0, in Compan. A, proportion is &67 and in compan. ), proportion is 8670 In such cases, compan. A is considered to be a highl. geared compan. and compan. ) is low geared compan.0

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apital structure describes how a corporation finances its assets0 This structure is usuall. a combination of se1eral sources of senior debt, me44anine debt and e2uit.0 9ise companies use the right combination of senior debt, me44anine debt and e2uit. to -eep their true cost of capital as low as possible0 #epending on how comple: the structure, there ma. in fact be do4ens of financing sources included, drawing on funds from a 1ariet. of entities in order to generate the complete financing pac-age0 Capital structure is what describes the relationship of these financing sources as the. appear on the corporation;s balance sheet0

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:amples of capital sources that ma. be included in a corporation;s capital structure are<

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 E2uit.

 Senior #ebt  e44anine #ebt

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ATTER"S 35 CAPITAL STRUCTURE

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he composition of capital structure can be recalled as follows< %0

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n the basis of sources of funds,

 Preference share capital  E2uit. share capital  #ebenture capital  Long/term debt  Reser1e and surplus  Current liabilit.  Share premium  P=L account

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n the basis of ownership capital,  E2uit. share capital

 Preference share capital  Reser1e and surplus

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n the basis of borrowed capital,  #ebenture capital

 Long/term debts  Cash credit

 Current liabilit.

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n the basis of cost of capital,  5i: cost of capital

 +ariable cost of capital

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n the basis of nature and t.pe of capital,

 Simple capital structure *when the capital structure is composed of a single source for e0g0 E2uit. capital including retained earnings 

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 Comple: capital structure *when the capital structure is composed of more than one source not of identical nature for e0g0 debenture, preference share, current liabilities

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APITAL STRUCTURE T!E3RIES

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st

Theory of Capital Structure

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ame of Theor. @ "et Income Theor. of Capital Structure

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his theor. gi1es the idea for increasing mar-et 1alue of firm and decreasing o1erall cost of capital0 A firm can choose a degree of capital structure in which debt is more than e2uit. share capital0 It will be helpful to increase the mar-et 1alue of firm and decrease the 1alue of o1erall cost of capital0 #ebt is cheap source of finance because its interest is deductible from net profit before ta:es0 After deduction of interest compan. has to pa. less ta: and thus, it will decrease the weighted a1erage cost of capital0

5or e:ample if .ou ha1e e2uit. debt mi: is 6'<6' but if .ou increase it as &'< ', it will increase the mar-et 1alue of firm and its positi1e effect on the 1alue of per share0

!igh debt content mi:ture of e2uit. debt mi: ratio is also called financial le1erage0 Increasing of financial le1erage will be helpful to for ma:imi4e the firmBs 1alue0

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nd

Theory of Capital Structure

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ame of Theor. @ "et 3perating income Theor. of Capital Structure

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et operating income theor. or approach does not accept the idea of increasing the financial le1erage under "I approach0 It means to change the capital

structure does not affect o1erall cost of capital and mar-et 1alue of firm0 At each and e1er. le1el of capital structure, mar-et 1alue of firm will be same0

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3

rd

Theory of Capital Structure

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ame of Theor. @ Traditional Theor. of Capital Structure

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his theor. or approach of capital structure is mi: of net income approach and net operating income approach of capital structure0 It has three stages

1st_Stae

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n the first stage which is also initial stage, compan. should increase debt contents in its e2uit. debt mi: for increasing the mar-et 1alue of firm0

2nd Stae

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n second stage, after increasing debt in e2uit. debt mi:, compan. gets the position of optimum capital structure, where weighted cost of capital is

minimum and mar-et 1alue of firm is ma:imum0 So, no need to further increase in debt in capital structure0

3rd Stae

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ompan. can gets loss in its mar-et 1alue because increasing the amount of debt in capital structure after its optimum le1el will definitel. increase the cost of debt and o1erall cost of capital0

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th

Theory of Capital Structure

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ame of theor. @ odigliani and iller

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 theor. or approach is full. opposite of traditional approach0 This approach sa.s that there is not an. relationship between capital structure and cost of

capital0 There will not effect of increasing debt on cost of capital0

+alue of firm and cost of capital is full. affected from in1estorBs e:pectations0 In1estorsB e:pectations ma. be further affected b. large numbers of other factors which ha1e been ignored b. traditional theorem of capital structure

5actors #etermining Capital Structure

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radin on E"uity# The word e2uit.D denotes the ownership of the

compan.0 Trading on e2uit. means ta-ing ad1antage of e2uit. share capital to borrowed funds on reasonable basis0 It refers to additional profits that e2uit. shareholders earn because of issuance of debentures and preference shares0 It is based on the thought that if the rate of di1idend on preference capital and the rate of interest on borrowed capital is lower than the general

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rate of compan.;s earnings, e2uit. shareholders are at ad1antage which means a compan. should go for a udicious blend of preference shares, e2uit. shares as well as debentures0 Trading on e2uit. becomes more important when e:pectations of shareholders are high0

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eree of control# In a compan., it is the directors who are so called elected representati1es of e2uit. shareholders0 These members ha1e got ma:imum 1oting rights in a concern as compared to the preference

shareholders and debenture holders0 Preference shareholders ha1e reasonabl. less 1oting rights while debenture holders ha1e no 1oting rights0 If the

compan.;s management policies are such that the. want to retain their 1oting rights in their hands, the capital structure consists of debenture holders and loans rather than e2uit. shares0

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le%i&ility of financial plan# In an enterprise, the capital structure should be such that there is both contractions as well as rela:ation in plans0

#ebentures and loans can be refunded bac- as the time re2uires0 9hile e2uit. capital cannot be refunded at an. point which pro1ides rigidit. to

plans0 Therefore, in order to ma-e the capital structure possible, the compan. should go for issue of debentures and other loans0

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hoice of in'estors# The Compan.;s polic. generall. is to ha1e different categories of in1estors for securities0 Therefore, a capital structure should gi1e enough choice to all -ind of in1estors to in1est0 )old and ad1enturous in1estors generall. go for e2uit. shares and loans and debentures are

generall. raised -eeping into mind conscious in1estors0

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apital (ar)et condition# In the lifetime of the compan., the mar-et price of the shares has got an important influence0 #uring the depression period, the compan.;s capital structure generall. consists of debentures and loans0 9hile in period of boons and inflation, the compan.;s capital should consist of share capital generall. e2uit. shares0

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eriod of financin# 9hen compan. wants to raise finance for short period, it goes for loans from ban-s and other institutionsG while for long period it goes for issue of shares and debentures0

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ost of financin# In a capital structure, the compan. has to loo- to the factor of cost when securities are raised0 It is seen that debentures at the time of profit earning of compan. pro1e to be a cheaper source of finance as

compared to e2uit. shares where e2uit. shareholders demand an e:tra share in profits0

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ta&ility of sales

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An established business which has a growing mar-et and high sales turno1er, the compan. is in position to meet fi:ed commitments0 Interest on debentures has to be paid regardless of profit0 Therefore, when sales are high, thereb. the profits are high and compan. is in better position to meet such fi:ed commitments li-e interest on debentures and di1idends on preference shares0 If compan. is ha1ing unstable sales, then the compan. is

not in position to meet fi:ed obligations0 So, e2uit. capital pro1es to be safe in such cases0

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i+es of a co(pany# Small si4e business firms capital structure generall. consists of loans from ban-s and retained profits0 9hile on the other hand, big companies ha1ing goodwill, stabilit. and an established profit can easil.

go for issuance of shares and debentures as well as loans and borrowings from financial institutions0 The bigger the si4e, the wider is total

capitali4ation0H

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eal ,e"uire(ents/The structure of capital of a compan. is also

influenced b. the statutor. re2uirements0 5or instance, ban-ing companies ha1e been prohibited b. the )an-ing Regulation Act to issue an. t.pe of securities e:cept e2uit. shares0

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I55ERE"CE )ET9EE" CAPITAL

A"# 5I"A"CIAL STRUCTURE

CA*ITAL ST,-CT-,E

FINANCIAL

ST,-CT-,E

I It refer to the permanent financing of the compan.0

I It refer to the wa. in which the firm;s assets are financed

II It comprise long/term debt and shareholder;s funds but e:clude short/term borrowings

II It comprises the total net worth and all liabilities as concern

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Capital structure treated as asset structure depends on nature of in1estment

II I

5inancial structure depends on sources of capital

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i1 In capital structure, there are ? main items

E2uit. share capital < Pref0 share capital < Long term debt <

Retained earning

i1 In financial structure, there are & main items

Long term liabilities < Current Liabilities

1 5inancial Structure is the base of capital structure0 9hole capital structure is the part of financial structure0

1 There are lots of basis of financial structure0 "ature of business, t.pe of business,

in1estment re2uirement, long term and wor-ing capital

re2uirement, cost of capital, and le1erage are its main factor which affects it0