Advanced financial Advanced financial managementmanagement

Corporate financeCorporate financeCapital structure: capital structure Capital structure: capital structure

refers to the make-up of its refers to the make-up of its capitalization and it includes all long capitalization and it includes all long

term capital resources like term capital resources like shares,loans,reserves and bonds shares,loans,reserves and bonds

Capitalization includes capital stock Capitalization includes capital stock and debt.and debt.

Capitalization is the total accounting Capitalization is the total accounting value of the stock, surprises in value of the stock, surprises in whatever form it may appear and whatever form it may appear and long term debtlong term debt

Essentials of an optimum capital Essentials of an optimum capital structurestructure

FlexibilityFlexibility EconomyEconomy SolvencySolvency EfficiencyEfficiency SimplicitySimplicity SafetySafety controlcontrol

Determinants of capital structureDeterminants of capital structure

Nature of businessNature of business Stability of earningStability of earning Growth rateGrowth rate Nature of investorsNature of investors ROIROI Trends in capital marketTrends in capital market Government regulations Government regulations

Capital structure decisionCapital structure decision

In capital structure decision such In capital structure decision such alternative should be selected which alternative should be selected which will give the highest EPS/MPS as the will give the highest EPS/MPS as the case may be.case may be.

Theories of capital structureTheories of capital structure

Net income approach Net income approach Net operating income approach Net operating income approach The traditional approachThe traditional approach MM approachMM approach

Net income approach: It states that a Net income approach: It states that a firm can minimize the WACC and firm can minimize the WACC and increase the value of the firm as well increase the value of the firm as well the market price of equity shares by the market price of equity shares by using debt financing to the maximum using debt financing to the maximum possible extent possible extent

Assumptions:Assumptions: The cost of debt is less than the cost The cost of debt is less than the cost

of equityof equity there are no taxesthere are no taxes The risk perceptions of the investors The risk perceptions of the investors

is not changed by the use of debt.is not changed by the use of debt.

The increase in the debt financing in The increase in the debt financing in the capital structure decreases the the capital structure decreases the proportion of equity capital and this proportion of equity capital and this results in decrease in the WACC results in decrease in the WACC resulting in an increase in the value resulting in an increase in the value of the firm.of the firm.

The cost of debt is less that the cost The cost of debt is less that the cost of equity because of two reasons :of equity because of two reasons :

Debt involves less risk than equityDebt involves less risk than equity Interest being a tax deductible Interest being a tax deductible

expensesexpenses

Net operating income approachNet operating income approach

Net operating income approach is Net operating income approach is propounded by Durand.This theory is propounded by Durand.This theory is diametrically opposite to the net diametrically opposite to the net income approach theory.income approach theory.

According to this theory changes in According to this theory changes in the capital structure of a company the capital structure of a company does not affect the market value of does not affect the market value of the and the overall cost of capital the and the overall cost of capital remains constant irrespective of the remains constant irrespective of the method of financing. The Debt-equity method of financing. The Debt-equity mix has no influence on the overall mix has no influence on the overall cost of capital of the firm cost of capital of the firm

AssumptionsAssumptions The market capitalizes the value of The market capitalizes the value of

the firm as a wholethe firm as a whole The business risk remains constant The business risk remains constant

at every level of debt-equity mix. at every level of debt-equity mix.

According to this theory with the According to this theory with the increased use of debt in the capital increased use of debt in the capital structure it increases the financial structure it increases the financial risk of the equity shareholders and risk of the equity shareholders and hence the cost of capital increaseshence the cost of capital increases

Traditional approach Traditional approach

According to this approach the cost According to this approach the cost of capital is not independent of the of capital is not independent of the capital structure of the firm and that capital structure of the firm and that there is an optimal capital structure. there is an optimal capital structure. There are two types of risksThere are two types of risks

Business riskBusiness risk Financial riskFinancial risk

AssumptionAssumption The capital structure of a firm consists of The capital structure of a firm consists of

only two kinds of capital debt and equity only two kinds of capital debt and equity sharesshares

The business risk of the company remains The business risk of the company remains constant overtime and is assumed to be constant overtime and is assumed to be independent of its capital structure and independent of its capital structure and financial riskfinancial risk

The firm has a perpetual lifeThe firm has a perpetual life Corporate income tax does not existCorporate income tax does not exist

Transaction costs are assumed to be Transaction costs are assumed to be nilnil

The operating income of the The operating income of the company is assumed not to grow company is assumed not to grow over time over time

The traditional theory states that the The traditional theory states that the financing pattern should include financing pattern should include moderate proportion of debt which moderate proportion of debt which would result in safety to the creditors would result in safety to the creditors claims as well as least cost claims as well as least cost accountingaccounting

Modigliani-Miller approachModigliani-Miller approach

This approach states that the This approach states that the average cost of capital of any firm is average cost of capital of any firm is independent of its capital structure independent of its capital structure and equal to the capitalization rate and equal to the capitalization rate of pure equity streams of its class. of pure equity streams of its class.

The value of the firm and cost of The value of the firm and cost of capital is the same for all the firms capital is the same for all the firms irrespective of the proportion of debt irrespective of the proportion of debt included in a firms capital structure.included in a firms capital structure.

Assumptions Assumptions All the firms in a class can be termed as All the firms in a class can be termed as

homogenous and placed in an equvalent homogenous and placed in an equvalent risk class.risk class.

Capital markets are perfect and Capital markets are perfect and investors are rationalinvestors are rational

There does not exist ant transactions There does not exist ant transactions costcost

The dividend payout ratio is 100 percentThe dividend payout ratio is 100 percent

CriticismsCriticisms Personal leverage is not equivalent to Personal leverage is not equivalent to

corporate leverage corporate leverage Due to the capital market imperfections Due to the capital market imperfections

the cost of borrowing may be higher than the cost of borrowing may be higher than for the individual than for the corporatefor the individual than for the corporate

In the actual practice there are In the actual practice there are transaction cost in the form of transaction cost in the form of brokerage,underwritting ,commission etc.brokerage,underwritting ,commission etc.