CAPITAL STRUCTURECapital Structure refers to the mix of long term

sources of funds, such as debentures, long term debt, preference share capital, equity share capital includes reserves and surplus.Capital structure should be well planned generally keeping in view the interest of the equity share holders and the financial requirements of a company.

FEATURES OF CAPITAL STRUCTURERETURNRISKFLEXIBILITYCAPACITYCONTROL

RETURNThe capital structure of the company should be

most advantageous. Subject to other considerations, it should generate maximum returns to the shareholders without adding additional cost to them.

RISKThe use of excessive risk threatens the

solvency of the company. To the point debt does not add significant risk it should be used, otherwise its use should be avoided.

FLEXIBILITYThe capital structure should be flexible. It should be possible for a company to adapt its capital structure with a minimum cost .

CAPACITYThe capital structure should be determined

within the debt capacity of the company, and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows.

CONTROLThe capital structure should involve minimum

risk of loss of control of the company.

FACTORS AFFECTING CAPITAL STRUCTURE1. Trading on equity.2. Retaining Control.3. Nature of Enterprise.4. Legal Requirements.5. Purpose of financing.6. Period of finance.7. Requirements of investors.8. Size of the company.9. Govt. Policy10. Provision for the future.

TRADING ON EQUITYA Company may raise funds either by issuing of

shares or by debentures. Debenture carry a fixed rate of interest and this interest can be paid irrespective of profit. Preference shares are also entitled a fixed rate of dividend. But payment of dividend depends upon the profitability of the company. In case the rate of return on the capital employed is more than the rate of interest on debentures or rate of dividend on preference shares, it is said that the company is on trading on equity

RETAINING CONTROLThe preference shareholders and debenture

holders have not much say in the management of the company.It is the equity shareholders who select the team of managerial personnel.

NATURE OF ENTERPRISEBusiness enterprises which have stability in

their earnings or which enjoy monopoly regarding their products may go for debentures or preference shares since they will have adequate profits to meet the recurring cost of interest/fixed dividend.

LEGAL REQUIREMENTSThe promoters of the company have also to

keep in view the legal requirements while deciding about the capital structure.Banking company which are not allowed to issue any type of security for raising funds except equity share capital on account of Banking Regulation Act.

PURPOSE OF FINANCINGThe purpose of financing also to some extent

affect the capital structure of the company.In case funds are required for some directly productive purposes.for ex: purchase of new machinery, the company can afford to raise the funds by issue of debentures. On the other hand if funds are required for non-productive purpose Eg. Construction of school or hospital, the company should raise the funds by the issue of equity shares

PERIOD OF FINANCEThe period for which finance is required also

affect the determination of capital structure of companies. In case funds are required, say for three to ten years, it will appropriate to raise them by issue of debenture rather than by issue of shares. However if the funds are required more or less permanently, it will be appropriate to raise them by issue of equity shares

REQUIREMENT OF INVESTORSDifferent types of securities are to be issued for

different classes of investors.Equity shares are best suited for bold or venture some investors. Debentures are suited for investors who are very cautious while preference shares are suitable for investors who are not very cautious.

SIZE OF THE COMPANYCompanies which are of small size have to rely

upon the owners funds for financing. Large companies are considered to be less risky by the investors and therefore they can issue different types of securities and collect their funds from different sources.

GOVERNMENT POLICYThe monetary and fiscal policies of the govt.

also affect the capital structure decision.

PROVISION FOR THE FUTUREWhile planning capital structure the provision

for future should also be kept in view.

PATTERNS OF CAPITAL STRUCTURECapital structure with equity shares only.Capital structure with both equity and

preference shares. Capital structure equity shares and

debentures.Capital structure with equity share,

preference share and debentures.

Basic difference between debt and equityDebt is the cheapest source of financeDebt is a liability on which interest has to be

paid irrespective of company’s profit. While equity consists of shareholders fund or owners fund on which payment of dividend depends upon the company’s profit

Raising of funds by borrowing is cheaper resulting in higher availability of profit for shareholders. This increases EPS of the company which is the basic objective of finance manager

Capital Structure theories1. Net Income Approach (NI) Suggested by Durand It says a change in the capital structure will lead to a

corresponding change in the overall cost of capital as well as the total value of the firm

If the ratio of debt to equity is increased, the weighted average cost of capital will decline, while the value of the firm will increase and vice versa

Assumptions:1. There are no taxes2. That the cost of debt is less than the equity capitalization

rate or cost of equity3. That the use of debt does not change the risk-perception

of investors

Capital Structure theories (cont…d)2. Net operating Income (NOI) Approach Also suggested by Durand This approach is diametrically opposite to the Net

Income Approach Any change in leverage or debt will not lead to any

change in the total value of the firm as the overall cost of capital is independent of the degree of leverage

The significant feature is that the equity capitalization rate, increases with the increase in the degree of leverage. The equity capitalization rate decreases with the decrease in the degree of leverage

Capital Structure theories (cont…d)

3. Modigliani-Miller (MM) Approach Suggested by Modigliani Miller MM is similar to NOI approach It suggests that the cost of capital of the

firm is an independent factor and has no concern with the capital structure

This theory implies that any change in capital structure of the concern does not affect the cost of capital

Capital Structure theories (cont…d)4. Traditional Approach This approach is a mid way between NI

approach and NOI approach