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    11a-Capital Structure TG1

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    Discovery School library
    Capital structure refers to the mix of debt and equity used by a company to finance its long-term operations. A company's capital structure is influenced by internal factors like size, nature of business, and external factors like capital market conditions and taxation policy. There are different theories on the optimal capital structure, including the net income theory which argues that increasing debt can maximize firm value by reducing costs, and the Modigliani-Miller theory which argues that the value and cost of capital of a firm are independent of its capital structure in the absence of taxes.

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    11a-Capital Structure TG1

    Uploaded by

    Discovery School library
    9 views17 pages
    Capital structure refers to the mix of debt and equity used by a company to finance its long-term operations. A company's capital structure is influenced by internal factors like size, nature of business, and external factors like capital market conditions and taxation policy. There are different theories on the optimal capital structure, including the net income theory which argues that increasing debt can maximize firm value by reducing costs, and the Modigliani-Miller theory which argues that the value and cost of capital of a firm are independent of its capital structure in the absence of taxes.

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    Capital structure refers to the mix of debt and equity used by a company to finance its long-term operations. A company's capital structure is influenced by internal factors like size, nature of business, and external factors like capital market conditions and taxation policy. There are different theories on the optimal capital structure, including the net income theory which argues that increasing debt can maximize firm value by reducing costs, and the Modigliani-Miller theory which argues that the value and cost of capital of a firm are independent of its capital structure in the absence of taxes.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    9 views17 pages

    11a-Capital Structure TG1

    Uploaded by

    Discovery School library
    Capital structure refers to the mix of debt and equity used by a company to finance its long-term operations. A company's capital structure is influenced by internal factors like size, nature of business, and external factors like capital market conditions and taxation policy. There are different theories on the optimal capital structure, including the net income theory which argues that increasing debt can maximize firm value by reducing costs, and the Modigliani-Miller theory which argues that the value and cost of capital of a firm are independent of its capital structure in the absence of taxes.

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    © All Rights Reserved
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    of 17

    Capital

    Structure
    Meaning of Capital StruCture
     CapitalStructure refers to the combination or mix of debt
    and equity which a company uses to finance its long term
    operations.
     Raising of capital from different sources and their use in
    different assets by a company is made on the basis of certain
    principles that provide a system of capital so that the
    maximum rate of return can be earned at a minimum cost.
    This sort of system of capital is known as capital structure.
    total required Capital
     From Shares
     Equity Share capital
     Preference Share Capital

     From Debentures
    faCtorS influenCing Capital
    StruCture
    Internal Factors

    External Factors
    internal faCtorS
     Size of Business
     Nature of Business
     Regularity and Certainty of Income
     Assets Structure
     Age of the Firm
     Desire to Retain Control
     Future Plans
     Operating Ratio
     Trading on Equity
     Period and Purpose of Financing
    external faCtorS
     Capital Market Conditions
     Nature of Investors
     Statutory Requirements
     Taxation Policy
     Policies of Financial Institutions
     Cost of Financing
     Seasonal Variations
     Economic Fluctuations
     Nature of Competition
    optiMal Capital StruCture
    The optimal or the best capital structure implies
    the most economical and safe ratio between
    various types of securities.

    It is that mix of debt and equity which maximizes


    the value of the company and minimizes the cost
    of capital.
    EssEntials of a sound or
    optimal Capital struCturE
     Minimum Cost of Capital
     Minimum Risk
     Maximum Return
     Maximum Control
     Safety
     Simplicity
     Flexibility
     Attractive Rules
     Commensurate to Legal Requirements
    thEoriEs of Capital struCturE
    Net Income (NI) Theory
    Net Operating Income (NOI) Theory
    Traditional Theory
    Modigliani-Miller (M-M) Theory
    nEt inComE (ni) thEory
    This theory was propounded by “David Durand” and is also
    known as “Fixed ‘Ke’ Theory”.
    According to this theory a firm can increase the value of the
    firm and reduce the overall cost of capital by increasing the
    proportion of debt in its capital structure to the maximum
    possible extent.
     It is due to the fact that debt is, generally a cheaper source of
    funds because:
    (i) Interest rates are lower than dividend rates due to element of risk,
    (ii) The benefit of tax as the interest is deductible expense for income
    tax purpose.
    Net Operating Income Theory
    This theory was propounded by “David Durand” and is
    also known as “Irrelevant Theory”.

    According to this theory, the total market value of the


    firm (V) is not affected by the change in the capital
    structure and the overall cost of capital (Ko) remains
    fixed irrespective of the debt-equity mix.
    Assumptions of NOI Theory
    The split of total capitalization between debt and equity
    is not essential or relevant.
    The equity shareholders and other investors i.e. the
    market capitalizes the value of the firm as a whole.
    The business risk at each level of debt-equity mix
    remains constant. Therefore, overall cost of capital also
    remains constant.
    The corporate income tax does not exist.
    Traditional Theory
    This theory was propounded by Ezra Solomon.
    According to this theory, a firm can reduce the overall
    cost of capital or increase the total value of the firm by
    increasing the debt proportion in its capital structure to a
    certain limit. Because debt is a cheap source of raising
    funds as compared to equity capital.
    Modigliani-Miller Theory
    This theory was propounded by Franco Modigliani and
    Merton Miller.
    They have given two approaches
     In the Absence of Corporate Taxes
     When Corporate Taxes Exist
    In the Absence of Corporate Taxes
    According to this approach the ‘V’ and its ‘Ko’ are
    independent of its capital structure.
    The debt-equity mix of the firm is irrelevant in
    determining the total value of the firm.
    Because with increased use of debt as a source of
    finance, ‘Ke’ increases and the advantage of low cost debt
    is offset equally by the increased ‘Ke’.
    In the opinion of them, two identical firms in all respect,
    except their capital structure, cannot have different
    market value or cost of capital due to Arbitrage Process.
    Assumptions of M-M Approach
    Perfect Capital Market
    No Transaction Cost
    Homogeneous Risk Class: Expected EBIT of all the firms
    have identical risk characteristics.
    Risk in terms of expected EBIT should also be identical
    for determination of market value of the shares
    Cent-Percent Distribution of earnings to the
    shareholders
    No Corporate Taxes: But later on in 1969 they removed
    this assumption.
    When Corporate Taxes Exist
    M-M’s original argument that the ‘V’ and ‘Ko’ remain
    constant with the increase of debt in capital structure,
    does not hold good when corporate taxes are assumed to
    exist.
    They recognised that the ‘V’ will increase and ‘Ko’ will
    decrease with the increase of debt in capital structure.
    They accepted that the value of levered (VL) firm will be
    greater than the value of unlevered firm (Vu).

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