INTRODUCTION
Capital is the major part of all kinds of business activities, which are decided by the size,
and nature of the business concern. Capital may be raised with the help of various sources.
If the company maintains proper and adequate level of capital, it will earn high profit and
they can provide more dividends to its shareholders.
Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts that make
up capitalization. It is the mix of different sources of long-term sources such as equity
shares, preference shares, debentures, long-term loans and retained earnings.
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.
Capital structure is the permanent financing of the company represented primarily by
long-term debt and equity.
Definition of Capital Structure
The following definitions clearly initiate, the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, “Capital Structure of a company refers
to the composition or make up of its capitalization and it includes all long-term capital
resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s permanent
long-term financing represented by debt, preferred stock, and common stock equity”.
According to the definition of Presana Chandra, “The composition of a firm’s
financing consists of equity, preference, and debt”.
48 Financial Management
According to the definition of R.H. Wessel, “The long term sources of fund employed
in a business enterprise”.
FINANCIAL STRUCTURE
The term financial structure is different from the capital structure. Financial structure
shows the pattern total financing. It measures the extent to which total funds are available
to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure and capital
structure.
Financial Structures Capital Structures
1. It includes both long-term and short-term sources of funds 1. It includes only the long-term sources
of funds.
2. It means the entire liabilities side of the balance sheet. 2. It means only the long-term liabilities
of the company.
3. Financial structures consist of all sources of capital. 3. It consist of equity, preference and
retained earning capital.
4. It will not be more important while determining the 4. It is one of the major determinations of
value of the firm. the value of the firm.
Example
From the following information, calculate the capitalization, capital structure and financial
structures.
Balance Sheet
Liabilities Assets
Equity share capital 50,000 Fixed assets 25,000
Preference share capital 5,000 Good will 10,000
Debentures 6,000 Stock 15,000
Retained earnings 4,000 Bills receivable 5,000
Bills payable 2,000 Debtors 5,000
Creditors 3,000 Cash and bank 10,000
70,000 70,000
(i) Calculation of Capitalization
S. No. Sources Amount
1. Equity share capital 50,000
2. Preference share capital 5,000
3. Debentures 6,000
Capitalization 61,000
Capital Structure 49
(ii) Calculation of Capital Structures
S. No. Sources Amount Proportion
1. Equity share capital 50,000 76.92
2. Preference share capital 5,000 7.69
3. Debentures 6,000 9.23
4. Retained earnings 4,000 6.16
65,000 100%
(iii) Calculation of Financial Structure
S. No. Sources Amount Proportion
1. Equity share capital 50,000 71.42
2. Preference share capital 5,000 7.14
3. Debentures 6,000 8.58
4 . Retained earnings 4,000 5.72
5. Bills payable 2,000 2.85
6. Creditors 3,000 4.29
70,000 100%
OPTIMUM CAPITAL STRUCTURE
Optimum capital structure is the capital structure at which the weighted average cost of
capital is minimum and thereby the value of the firm is maximum.
Optimum capital structure may be defined as the capital structure or combination of
debt and equity, that leads to the maximum value of the firm.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Forms of Capital Structure
Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.
FACTORS DETERMINING CAPITAL STRUCTURE
The following factors are considered while deciding the capital structure of the firm.
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.
Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a firm.
Normally long- term finance such as equity and debt consist of fixed cost while mobilization.
When the cost of capital increases, value of the firm will also decrease. Hence the firm
must take careful steps to reduce the cost of capital.
(a) Nature of the business: Use of fixed interest/dividend bearing finance depends
upon the nature of the business. If the business consists of long period of
operation, it will apply for equity than debt, and it will reduce the cost of capital.
(b) Size of the company: It also affects the capital structure of a firm. If the firm
belongs to large scale, it can manage the financial requirements with the help of
internal sources. But if it is small size, they will go for external finance. It consists
of high cost of capital.
(c) Legal requirements: Legal requirements are also one of the considerations while
dividing the capital structure of a firm. For example, banking companies are
restricted to raise funds from some sources.
(d) Requirement of investors: In order to collect funds from different type of
investors, it will be appropriate for the companies to issue different sources of
securities.
Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, longterm
funds from external sources. Hence the company must consider government policy
regarding the capital structure.
CAPITAL STRUCTURE THEORIES
Capital structure is the major part of the firm’s financial decision which affects the value of
the firm and it leads to change EBIT and market value of the shares. There is a relationship
among the capital structure, cost of capital and value of the firm. The aim of effective capital
structure is to maximize the value of the firm and to reduce the cost of capital.
There are two major theories explaining the relationship between capital structure,
cost of capital and value of the firm.
Capital Structure Theories
Modern A pproa ch Tra dition al Approach
Net Income
Approach
Net O perating Income
Approach
Mod ig lian i-Mille r
Approach
Capital Structure Theories
Traditional Approach
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and
equity capital can increase the value of the firm by reducing overall cost of capital up to
certain level of debt. Traditional approach states that the Ko decreases only within the
responsible limit of financial leverage and when reaching the minimum level, it starts
increasing with financial leverage.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:
• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.
Capital is the major part of all kinds of business activities, which are decided by the size,
and nature of the business concern. Capital may be raised with the help of various sources.
If the company maintains proper and adequate level of capital, it will earn high profit and
they can provide more dividends to its shareholders.
Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts that make
up capitalization. It is the mix of different sources of long-term sources such as equity
shares, preference shares, debentures, long-term loans and retained earnings.
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.
Capital structure is the permanent financing of the company represented primarily by
long-term debt and equity.
Definition of Capital Structure
The following definitions clearly initiate, the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, “Capital Structure of a company refers
to the composition or make up of its capitalization and it includes all long-term capital
resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s permanent
long-term financing represented by debt, preferred stock, and common stock equity”.
According to the definition of Presana Chandra, “The composition of a firm’s
financing consists of equity, preference, and debt”.
48 Financial Management
According to the definition of R.H. Wessel, “The long term sources of fund employed
in a business enterprise”.
FINANCIAL STRUCTURE
The term financial structure is different from the capital structure. Financial structure
shows the pattern total financing. It measures the extent to which total funds are available
to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure and capital
structure.
Financial Structures Capital Structures
1. It includes both long-term and short-term sources of funds 1. It includes only the long-term sources
of funds.
2. It means the entire liabilities side of the balance sheet. 2. It means only the long-term liabilities
of the company.
3. Financial structures consist of all sources of capital. 3. It consist of equity, preference and
retained earning capital.
4. It will not be more important while determining the 4. It is one of the major determinations of
value of the firm. the value of the firm.
Example
From the following information, calculate the capitalization, capital structure and financial
structures.
Balance Sheet
Liabilities Assets
Equity share capital 50,000 Fixed assets 25,000
Preference share capital 5,000 Good will 10,000
Debentures 6,000 Stock 15,000
Retained earnings 4,000 Bills receivable 5,000
Bills payable 2,000 Debtors 5,000
Creditors 3,000 Cash and bank 10,000
70,000 70,000
(i) Calculation of Capitalization
S. No. Sources Amount
1. Equity share capital 50,000
2. Preference share capital 5,000
3. Debentures 6,000
Capitalization 61,000
Capital Structure 49
(ii) Calculation of Capital Structures
S. No. Sources Amount Proportion
1. Equity share capital 50,000 76.92
2. Preference share capital 5,000 7.69
3. Debentures 6,000 9.23
4. Retained earnings 4,000 6.16
65,000 100%
(iii) Calculation of Financial Structure
S. No. Sources Amount Proportion
1. Equity share capital 50,000 71.42
2. Preference share capital 5,000 7.14
3. Debentures 6,000 8.58
4 . Retained earnings 4,000 5.72
5. Bills payable 2,000 2.85
6. Creditors 3,000 4.29
70,000 100%
OPTIMUM CAPITAL STRUCTURE
Optimum capital structure is the capital structure at which the weighted average cost of
capital is minimum and thereby the value of the firm is maximum.
Optimum capital structure may be defined as the capital structure or combination of
debt and equity, that leads to the maximum value of the firm.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Forms of Capital Structure
Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.
FACTORS DETERMINING CAPITAL STRUCTURE
The following factors are considered while deciding the capital structure of the firm.
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.
Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a firm.
Normally long- term finance such as equity and debt consist of fixed cost while mobilization.
When the cost of capital increases, value of the firm will also decrease. Hence the firm
must take careful steps to reduce the cost of capital.
(a) Nature of the business: Use of fixed interest/dividend bearing finance depends
upon the nature of the business. If the business consists of long period of
operation, it will apply for equity than debt, and it will reduce the cost of capital.
(b) Size of the company: It also affects the capital structure of a firm. If the firm
belongs to large scale, it can manage the financial requirements with the help of
internal sources. But if it is small size, they will go for external finance. It consists
of high cost of capital.
(c) Legal requirements: Legal requirements are also one of the considerations while
dividing the capital structure of a firm. For example, banking companies are
restricted to raise funds from some sources.
(d) Requirement of investors: In order to collect funds from different type of
investors, it will be appropriate for the companies to issue different sources of
securities.
Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, longterm
funds from external sources. Hence the company must consider government policy
regarding the capital structure.
CAPITAL STRUCTURE THEORIES
Capital structure is the major part of the firm’s financial decision which affects the value of
the firm and it leads to change EBIT and market value of the shares. There is a relationship
among the capital structure, cost of capital and value of the firm. The aim of effective capital
structure is to maximize the value of the firm and to reduce the cost of capital.
There are two major theories explaining the relationship between capital structure,
cost of capital and value of the firm.
Capital Structure Theories
Modern A pproa ch Tra dition al Approach
Net Income
Approach
Net O perating Income
Approach
Mod ig lian i-Mille r
Approach
Capital Structure Theories
Traditional Approach
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and
equity capital can increase the value of the firm by reducing overall cost of capital up to
certain level of debt. Traditional approach states that the Ko decreases only within the
responsible limit of financial leverage and when reaching the minimum level, it starts
increasing with financial leverage.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:
• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.
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