2. CAPITAL STRUCTURE
Capital 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.

3. FEATURES OF CAPITAL STRUCTURE
RETURN
RISK
FLEXIBILITY
CAPACITY
CONTROL

4. RETURN
The 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.

5. RISK
The 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.

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

7. CAPACITY
The 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.

8. CONTROL
The capital structure should involve minimum risk of
loss of control of the company.

9. FACTORS AFFECTING CAPITAL
STRUCTURE
1. 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. Policy
10. Provision for the future.

10. TRADING ON EQUITY
A 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

11. RETAINING CONTROL
The 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.

12. NATURE OF ENTERPRISE
Business 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.

13. LEGAL REQUIREMENTS
The 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.

14. PURPOSE OF FINANCING
The 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

15. PERIOD OF FINANCE
The 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

16. REQUIREMENT OF INVESTORS
Different 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.

17. SIZE OF THE COMPANY
Companies 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.

18. GOVERNMENT POLICY
The monetary and fiscal policies of the govt. also affect
the capital structure decision.

19. PROVISION FOR THE FUTURE
While planning capital structure the provision for
future should also be kept in view.

20. PATTERNS OF CAPITAL STRUCTURE
Capital 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.

21. Basic difference between debt and equity
Debt is the cheapest source of finance
Debt 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

22. Capital Structure theories
1. 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 taxes
2. That the cost of debt is less than the equity capitalization rate or
cost of equity
3. That the use of debt does not change the risk-perception of
investors

23. 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

24. 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

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