Capital Structure Planning: Unit: 3
Capital Structure Planning: Unit: 3
Capital Structure Planning: Unit: 3
UNIT : 3
Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts
The term capital structure refers to the relationship between the various long-
term source financing such as equity capital, preference share capital and debt
capital. Deciding the suitable capital structure is the important decision of the
financial management because it is closely related to the value of the firm.
Simplicity
Safety of cost
Minimum cost
Maximum return
Flexibility
Proper liquidity
Objectives of Capital Structure
Leverage : It is the basic and important factor, which affect the capital
structure. It uses the fixed cost financing such as debt, equity and
preference share capital. It is closely related to the overall cost of
capital.
Legal requirements
Requirement of investors
CAPITAL STRUCTURE THEORIES
Net Income (NI) Approach
where
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of the equity can be ascertained by the following
formula:
S = NI/Ke
where
NI = Earnings available to equity shareholder
Ke = Cost of equity/equity capitalization rate
Format for calculating value of the firm on the
basis of NI approach.
Net Operating Income (NOI) Approach
V= EBIT / K0
Where,
No Transaction Costs
The use of long term fixed interest bearing debt and preference share
capital along with equity share capital is called financial leverage or
trading on equity
It measures the effect of the change in EBIT(operating profit)on the
EPS(earning per share)of the company
The risk associated with financial leverage is called financial risk .
Financial risk is the risk of not being able to cover fixed financial costs
by the firm
Financial leverage may be favorable or unfavorable
depends upon the use of fixed cost funds
Where,
PD = preference dividend
t = tax rate
Degree of Financial Leverage