�ݺ�ߣ

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.

Sources
of long
term
finance
Proprietor’
s funds
Equit
y
capita
l
Preferenc
e
capital
Reserve
and
surplus
Borrowe
d
funds
Long
term
debts

 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

 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

 Rate of corporate
tax
 Retaining control
 Flexibility
 Trading on equity
 Legal requirement
 Assets structure
 Nature of investor

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

(X-I1)(1-T)-PD
S1
= (X-I2)(1-T)-PD
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

capitalstructureppt-151108185737-lva1-app6891.pptx

Net income
approach
Net operating
income approach
Traditional approach
Modigliani and miller
approach
Capital
structure
theories

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

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

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.

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

TRADITIONAL APPROACH
 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

MODIGLIANI-MILLER
APPROACH
 They have given two approach
1. In the absence of corporate taxes
2. When corporate taxes exist

Assumption :-
 Capital market are perfect
 Homogeneous risk classes of firm
 Expectations about the net operating
income
 100% payout ration
 No corporate tax

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.

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

 Optimum capital structure is a
capital structure at which market
value per share is maximum and
the cost of capital is minimum

Simplicity
flexibility
Minimum
risk
Minimum cost of
capital Sufficient
liquidity Retaining

 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

A. BC 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

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
4000
0
1500
0
1500
0
40000
0
30000
0
20000
0
EPS Rs.10 Rs.20 Rs.13.33

 Goel DK, Management accounting and
financial management, APC
 Gupta Shashi K., financial management and
policy, kalyani publication

�ݺ�ߣ

capitalstructureppt-151108185737-lva1-app6891.pptx

More Related Content

capitalstructureppt-151108185737-lva1-app6891.pptx