CAPITAL STRUCTURE

Capital structure refers to the portfolio of different sources of capital

employed by a business. It is the mix of capital. It is the structure of long term
liabilities of a business. Capital structure analysis is considered with the equity
and debt composition of capital of a business.

According to James C. Van Horne, ―The mix of a firm‘s permanent long-

term financing represented by debt, preferred stock, and common stock
equity‖.

According to Gerstenberg, ―Capital structure of a company refers to the

composition or make- up of its capitalisation and it includes all long-term
capital resources viz: loans, reserves, shares and bonds‖.

Components of Capital Structure

Components of ‗capital funds‘ of a company may be classified on the basis of

their sources. Accordingly, they are put into two categories:

1) Owner’s Capital: Issue of shares is the most important sources for

raising the permanent working capital. Shares are of two types – Equity
shares and preference shares. Maximum amount of permanent working
capital should be raised by the issue of equity shares.

Owner‘s Capital consists of one or more of the following

items:
i) Equity Shares: These are the elementary sources of raising funds for an
entrepreneur to start a business. Amongst all the components of ‗Capital
Structure‘ of a company, equity capital is the most costly source of fund. As
the holders of equity capital are true owners of a company, they have highest
level of business risk. The balance of net profit, after payment to all other
 claimants, is distributed amongst all the equity shareholders of a company as
dividend.

ii) Preference Shares: These shares are given preference over the ordinary
shares in following respects:
a. The dividend should be paid every year by the company without any delay
to the preference shareholder, prior to dividend payout on ordinary
shareholders.
b. The dividend should be paid at a fixed rate to the preference shareholders.
c. The return of capital should be repaid first to the Preference share holders
at the time of winding-up of the company.

iii) Retained Earnings : are that portion of earnings ( profit after tax less
preference dividend) which are ploughed back in the company. Company
normally retain 30 % to 80 % of profit after tax for financing growth.
In a company balance sheet the Reserve and Surplus (other than share
premium reserve and revaluation reserve) , which essentially represent
accumulated retained earnings, are an important source of long term
financing.
A part of the net profit earned during the year, set aside for investment purpose
or reinvestment in the business, is termed as ‗retained earnings‘. This is
viewed as the most convenient source of internal finance and is utilised by the
company for growth, expansion and diversification of the business.

2) Borrowed Capital

The fund, which is required for 7 to 20 years and above, is called long-term
funds. Financing of working capital through long-term sources provides
reduction of risk and increases the liquidity. These long-term sources can be
raised through the following methods:
 Bonds

And

Shares
Long term Term Loan
maturities of
finance lease
obligations From Banks /
FIs

LONG TERM
BORROWINGS
Loans and Deferred
Advances from
Payment

Friends and liabilities

relatives

Deposits
 Borrowings shall further be sub-classified as secured and unsecured.
Nature of securities shall be specified in each case. Terms of repayment
of term loans and other loans shall be stated.

Capital borrowed may be of the following types:

i) Debentures / Bonds: A debenture is an instrument issued by the company

acknowledging its debt to its holder. It is also an important source of long-
term working capital. The firm issuing debenture also enjoys a number of
benefits, such as trading on equity, retention of control, tax benefit etc.
When funds are raised through this mode, a company enters into a
contract with the subscribers of the instrument (debenture) regarding the
acknowledgement of the debt and payment of interest and principal.
Debentures have fixed interest rate of payment and are repayable on a
fixed maturity date.

ii)Long-term loans:
Financing institutions such as commercial banks, life insurance
corporation of India, industrial finance corporation of India, state financial
corporations, industrial development bank of India etc. provide long-term
and medium-term loans. This type of finance is ordinarily repayable in
instalments.

iii) Financing through medium-term sources.

The funds, which are basically required for a period of 2 to 5 years, are
called medium-term funds. Previously the commercial banks were
concentrating on short-term and medium-term loans in the form of
working capital loans whereas the financial institutions like IDBI, ICICI, IFCI
were concentrating on long-term funds.
But, recently, the commercial banks have also entered into providing
medium-term as well as long-term funds to trade and industry, either
independently, or sometimes, in collaboration with one or more
specialized financing institutions. The medium-term funds can be raised
through the following methods:
iv) Term Loans: ‗Term Loans‘ are institutional borrowings opted by
companies as a source of long-term funds. The lenders are commercial
banks and other financial institutions and they charge a fixed rate of
interest for a period of three years or more. Term loans are loans secured
against mortgage of property or any other security acceptable to the
lending institutions.

v. Public fixed deposits:

Public deposits are the fixed deposits accepted by a business enterprise (
with lot of restrictions) directly from public deposit as source finance have
a large number of advantages such as simple and convenient source of
finance, Taxation benefits, inexpensive sources of finance etc.

3.3 NET INCOME APPROACH

Net Income approach as suggested by Durand David, the capital

structure decision is relevant to the valuation of the firm. A change in the
financial leverage will lead to a corresponding change in the overall cost
of capital as well as the total value of the firm. A higher debt content in
the capital structure means a high financial leverage and this results in
decline in the overall or weighted average cost of capital.

For example, if the equity-debt mix of a company is changed from 50 : 50

to 80 : 20, the impact on the WACC would be a positive one, i.e., WACC
would be reduced, which would lead to the increase in the value of the
company and its shares.

There is usually three basic assumptions of this approach:

- Corporate taxes do not exist.

- Debt content does not change the risk perception of the
investors.
- Cost of debt is less than cost of equity i.e. debt capitalization
rate is less than theequity capitalization rate.
The implication of the three assumptions underlying the NI approach
is that as the degree of leverage increases, the proportion of a cheaper
source of funds, that is, debt in the capital structure increase.

With the judicious mixture of debt and equity, a firm can evolve an
optimum capital structure which will be the one at which value of the firm
is the highest and overall cost of capital is the lowest. At that structure,
the market price per share would be maximum.
Valuation of a Company

The total value of a company on the basis of NI Approach may be

computed by applying following formula:

V=S+D Where,
V = Total Value of the Firm,
S = Market Value of Equity,
D = Market Value of Debt.

Market value of Equity may be calculated with the help of the

following formula:

S = NI/Ke Where,
S = Market Value of Equity,
Ke = Cost of Equity Capital or Equity
Capitalisation Rate,
NI = Earnings available for equity
shareholders

The overall cost of capital can be ascertained as follows:

Overall Cost of Capital (Ko ) = EBIT / V
Where, EBIT = Earnings before Interest and Tax, V = Total value of the firm.

3.4 NET OPERATING INCOME APPROACH

As per the Net Operating Income Approach, value of the firm is

independent of its capital structure. It assumes that the weighted
average cost of capital is unchanged irrespective of the level of gearing.
Any change in leverage will not lead to any change in the total value of
the firm and the market price of the shares as well as the overall cost of
capital is independent of the degree of leverage.
NOI approach is opposite to the NI approach. According to this
approach, the market value of the firm depends upon the net operating
profit or EBIT and the overall cost of capital, weighted average cost of
capital (WACC) . The financing mix or the capital structure is irrelevant
and does not affect the value of the firm.
Assumptions:

The NOI approach is based on certain assumptions:

- The investors see the firm as a whole and thus capitalize the
total earnings of thefirm to find the value of the firm as a
whole.
- The overall cost of capital (K0) of the firm is constant and
depends upon thebusiness risk which also is assumed to be
unchanged.
- The cost of debt (Kd) is also constant.
- There is no tax
- The use of more and more debt in the capital structure
increases the risk of theshareholders and thus results in the
increase in the cost of equity capital (ke).
The total value of the firm on the basis of NOI Approach can be
ascertained as follows:
Total Value of Firm (V) = EBIT/Ko or NOI/Ko Where,

V = Total value of the firm,

EBIT = Earning before Interest and Tax
NOI = Net operating income,
Ko = Overall cost of capital.

The total value of the equity on the basis of NOI Approach can be
ascertained as follows:
Total Value of Equity (E) = V – D Where,
V = Total Value of the Firm, D = Total Value of Debt
Thus the financing mix is irrelevant and does not affect the value of the
firm. The valueremains same for all types of debt - equity mix.