Capital Structure :

  Capital Structure :

Let us take an example Mr. A manage garage the Automobile workshop along with the servicemen B. Mr. B observed so many time that Mr. A allows discount and if customer is not satisfied he allow him to go without making payments. One day Mr. B asked Mr. A ‘‘How do you manage? and why do you keep loosing every day’’. Mr. A replied, ‘‘I do this for continuing business and to survive in the market. Few years passed Mr. B resigned from job. Mr. A asked why you resigned. Mr. B replied as my uncle died and he transferred his millions of property to me so no need of working. I will lend money and live peacefully. Mr. A sensed good opportunity to grow. He asked Mr. B why don’t you lend money to me? With your Money I will added more facilities and increase the business and which lead to expansion and diversification of business.

Mr. B agress but he started interfering in Mr. A’s business as he is worried about his interest and his return of principal amount balance if Mr. A is going to continue the practices of allowing discount and let customer go without payment will lead to loss of business and his interest and principal  will be lost. Mr. A started thinking did I had taken right decision to borrow money from Mr. B. He got mixed thinking in his mind, positive as well as negative. Positive as he got money he expanded, got more facilities and he grew at the same time negative was that Mr. B started interfering in his business.

From the above example, it is clear that Mr. A is in dilemina. (1) Whether to continue to borrow from B as it gives fund which is required to expand or to (2) Stop or restrict to some extent interfering in business. (3) Or to have balance structure and strategies so that he can borrow and give Mr. B good return so that he will not interfere in business as he received his money.

This type of situation is faced by almost all the organizations and this decision is known as capital structure of the company.

Capital structure means financial structure of the organization Financial structure include debt as well as equity. Capital structure decision refers to the proportion of debt and equity and find out whether there is a capital structure that can be said to be optimum for the shareholder of the firm.

Proforma                        Formulae

EBIT X

Less: INT (X) (1) Value of firm =  or

EBT X Or value of Debt + value of equity

Less: Tax (X) (2) Value of Debt =

EAT X (3) Value of equity =  

Less: Pref. dividend (X)

Earning to Equity Share (i) X or =

No. of shares (ii) X

EPS (1/11) X

PE rate X X

Mkt price EPS × PE

                                                                            (4)ROCE =  × 100

There are 3 approaches to capital structure

(1) Net income approach (value of firm depend on C.S.)

Net income approach is based on the following Assumptions.

There is a relationship between CS and value of firm i.e. company can affects its value by increasing or decreasing debt proportion in overall finance mixed.

● Cost of Debt and cost of equity remain constant in all different debt equity mix. It implies that the supplier of debt and equity capital are not concerned with level of debt the firm has instead they are concerned with their desired returns respectively.

● Cost of debt is less than cost of equity

Kd < Ke

As per this assumption cost of debt is consider cheaper capital and cost of equity is considered as expensive capital. Means whenever equity proportion (Expensive Capital) in overall capital employed is replaced by debt fund (cheaper fud) then over all cost of capital will reduce.

(3) When debt is 0 then K0 = Ke means high cost of capital accordingly to this theory debt is a cheaper capital and should be given first preference i.e. optimum capital structure is that structure where the firm can borrow at maximum of its  capacity.

(4) When Kd increase Ko come down as Debt proportion income then expensive propostion leads to Reduction in overall cost of capital i.e. Ko

(2) Net operating income approach – (Value of firm depend on Operating profit Not on capital structure)

Ko – remain constant

This approach is exactly to opposite NI approach. It indicates that capital structure has nothing to do with value of firm. The value of firm depend on earning available to shareholders. They assume that Kd remain constant and Ko remain constant.

As company borrowing more and more of Debt fund which is considered as cheaper fund the external liability also increases as a result equity shareholder feels that their risk of getting return is also increasing (because outside liability is more) which company need to make payment first.) risk increase leads to increase in cost i.e. equity shareholder also expect more rather in the form of dividend Ke)

This approach says that in Ko whenever equity proportion is replaced by Debt proportion i.e. expensive capital replaced by cheaper capital. Ko will be reduced because of low cost Debt but increase in Debt lead to increase Risk to equity leads to rise in equity cost which will set off this low cost benefit therefore overall cost of capital will come back to its old rate. (i.e. constant)

As per this approach there is no specific capital structure which we call as optimum C.S.

Ko = Ke

Ke  and value of firm remain constant

MM Approach

MM approach is practical application of NOI approach by arbitrage process.

MM says that value of firm remain same as determined its assets, no matter how they are acquired. It has nothing to do with capital structure. It state that value of firm remain same, only the nature of claims on the earning change with change in Debt ratio. Just as the slice of bread does not change no matter how many slices are cut into and who shares those slice, the value of firm remain constant no matter how the earning are shared between debt holder and equity holder