The document discusses capital structure and its theories. It defines capital structure as the proportion of long-term debt and equity used to finance a company's assets. A company's capital structure determines its risk and cost of capital. There are several theories on capital structure including the net income, net operating income, traditional, and Modigliani-Miller approaches. The optimal capital structure balances minimum costs and risks. Factors like tax rates, control, flexibility, and legal requirements influence a company's choice of capital structure.
2. MEANING OF CAPITAL STRUCTURE
Capital structure refer to the proportion between the
various long term source of finance in the total
capital of firm
A financial manager choose that source of finance
which include minimum risk as well as minimum
cost of capital.
4. Capital structure determine the risk assumed by the
firm
Capital structure determine the cost of capital of the
firm
It affect the flexibility and liquidity of the firm
It affect the control of the owner of the firm
5. Nature and Size of the firm
Stability of the earning
Stages of life cycle of the firm
Cash flow ability of the firm
Cost of capital
6. Rate of corporate tax
Retaining control
Flexibility
Trading on equity
Legal requirement
Assets structure
Nature of investor
7. It refer to that EBIT level, at which EPS remain
same irrespective of different alternatives of debt-
equity mix.
At this level of EBIT return on capital employed is
equal to cost of debt this is also known as break
even level of EBIT for alternative financial plan
8. (X-I1)(1-T)-PD = (X-I2)(1-T)-PD
S1 S2
Where
X = point of indifference
I1 = int. under alternative financial plan 1
I2= int. under alternative financial plan 2
T = tax rate
PD = pref. dividend
S1 = amount of equity share under financial plan 1
S2= amount of equity share under financial plan 2
11. NET INCOME (NI) THEORIES
This theory is suggested by “David Durand”
Acc. to this approach the value of the firm is
increase and decrease overall cost of capital by
increasing the proportion of debt financing in capital
structure
It is due to the fact that debt is generally a cheaper
sources of finance because:
1. Interest rate are lower than the dividend rate
2. Benefit of tax because int. is deductible
expense
12. ASSUMPTION OF NET INCOME
APPROACH
The cost of debt is lower than cost of equity
The risk perception of the investor is not changed
by the use of debt
There is no corporate tax
14. NET OPERATING INCOME APPROACH
This theory was propounded by “David Durand” and
is also known as irrelevant theory.
Acc. to this theory, the total market value of the firm
is not affected by the change in the capital structure
and the overall cost of capital remain constant
irrespective of debt-equity ratio.
15. ASSUMPTION OF NET OPERATING INCOME
APPROACH
The market capitalizes the value of the firm as a
whole. Thus, the split between debt and equity is
not important
The cost of debt is lower than cost of equity
The risk perception of the investor is not changed
by the use of debt
There is no corporate tax
16.
17. TRADITIONALAPPROACH
This approach is the midway of NI approach and NOI
approach. And also known as intermediate approach.
Acc. to this, the value of firm can be increased initially or
cost of capital can be decreased by using more debt as the
debt is a cheaper source of fund than equity
After that optimum capital structure can be reached by a
proper debt-equity mix
But after a particular point if the proportion of debt is
increased, then the overall cost of capital start increasing
and market value begin to decline
20. Assumption :-
Capital market are perfect
Homogeneous risk classes of firm
Expectations about the net operating income
100% payout ration
No corporate tax
21. IN THE ABSENCE OF CORPORATE TAXES
Acc. To this theory total value of a firm must be
constant irrespective of degree of leverage, i.e.
debt-equity ratio. This can be justified by arbitrage
process .
This approach is similar to the net operating income
approach when taxes are ignored
It means capital structure decision of a firm is not
affect its market value.
22. WHEN CORPORATE TAX ARE ASSUMED TO
EXIST
Acc. to this value of the firm increase and cost of
capital decrease with the use of debt if corporate
tax are considered. This is because of Benefit of tax
because int. on tax is deductible expense
23. Optimum capital structure is a capital
structure at which market value per
share is maximum and the cost of
capital is minimum
25. EPS = (EBIT-I)(I-t)-PD
n
Where :
EPS = earning per share
EBIT = earning before int. and tax
I = int. charged per annum
t = tax rate
PD = preference dividend
n = no. of equity shares
26. Q-ABC company has currently an all equity structure
consisting of 15000 equity shares of rs.100 each. The
management is planning to raise another rs.25 lakhs to
finance a major programme of expansion and it consider
three alternative method of financing
To issue 25000 equity share of rs.100 each
To issue 25000, 8% debenture of rs.100 each
To issue 25000, preference share of rs.100 each
the company EBIT will be 8 lakhs. Assuming a corporate
tax of 50%, determine earning per share in each alternative
27. Alternative 1
equity financing
Alternative 2 debt
financing
Alter. 3 pref. share
financing
EBIT 8.00 8.00 8.00
Less int. - 2.00 -
Earning after int. but
before tax
8.00 6.00 8.00
Less tax @50% 4.00 3.00 4.00
EAT 4.00 3.00 4.00
Less pref. dividend - - 2.00
E available to equity
shareholders
4.00 3.00 2.00
No. of equity share 40000 15000 15000
400000 300000 200000
EPS Rs.10 Rs.20 Rs.13.33
28. Goel DK, Management accounting and financial
management, APC
Gupta Shashi K., financial management and policy,
kalyani publication
