CAPITAL Sructure

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CAPITAL

STRUCTURE


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INTRODUCTION

In order to run and manage acompany, funds are needed. If

funds are inadequate, the businesssuffers and if the funds are notproperly managed, the entire

organization suffers. It is necessarythat correct estimate of optimumcapital structure which shall help

the organization to run its work


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MEANINGThe term capital structure refersto the relationship between the

various longterm financing suchas debentures, preference capital,equity share capital.

There should be a proper mix ofdebt and equity capital in financingthe firms assets. The use of longterm debt and reference ca ital


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FINANCIAL BREAK

EVEN POINTIt may be defined as that level ofEBIT which is just equal to pay total

financial charges i.e. interest andpreference dividend.

EBIT= interest+ preferencedividend.

At this point earning per share is

equal to zero.


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FINANCIAL BREAK

EVEN POINT(a) when the capital structureconsists of equity share capital and

debt only and no preference capitalis employed:financial break even point = fixed

intrest charges.


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Financial break even

point(b) When the capital structureconsists of equity, preference and

debt:

FBEP = I + Dp/(1-t)

Where, I = fixed interest chargesDp = preference dividend

(1-t) = tax rate


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NETINCOME

APPROACHUnder net income approach cost ofequity and cost of debt are

constant as debt is replaced forequity in capital structure, beingless expensive , it causes the

overall cost of capital decreasethat ultimately approaches the costof debt with 100% debt ratio.

Under net income approach, the


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ASSUMPTION(1)There are no taxes.

(2)The risk perception of investor

is not changed by use of debt.

(3)Debt is replaced for equity

(4) Firm uses only two sources offinance i.e. equity and debt.


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formulaeV = S+D

S = EBIT- I/ equity capitalizationrate

Ko = EBIT/ V

V= value of firm

S= value of equity shares

D= value of debt


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EXAMPLES(a) A company expects a net

income of Rs. 80,000. it has Rs.

2,00,000. 8% debentures. Theequity capitalization rate of thecompany is 10% calculate the

value of the firm and overallcapitalization rate according tothe net income approach.

b If the debt is increased to Rs.


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NET OPERATING

INCOME APPROACHThe change in capital structure of acompany does not affect the

market value of the firm andoverall cost of capital remainssame. In other words, the overall

cost of capital remains samewhether debt or equity mix is50:50, 20:80, 0: 100. thus, there is

nothing as optimal capital


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ASSUMPTION(1)The overall cost of capital

remains constant.

(2)The risk perception of investoris changed by use of debt.

(3) increase in Cost of equityoffsets the benefits of usingcheaper source of finance.


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NET OPERATING

INCOME APPROACHV = EBIT/ K0

S = V D

Ke = EBIT- I/ V- D

V= value of firm

Ko = overall cost of capital.

S= market value of a equity

D = market value of debt


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EXAMPLE

(a) A company expects a netoperating income of Rs.

1,00,000. it has Rs. 5,00,000.6% debentures. The overallcapitalization rate is 10%.

Calculate the value of the firmand the equity capitalizationrate according to the net

operating income approach.


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TRADITIONAL

APPROACHThe value of firm can be increasedinitially or cost of capital can be

decreased by using more debt asdebt is cheaper source of financethan equity. Like, net income

approach this approach impliescost of capital decreases only within reasonable limit and reaching

the minimum level, it starts


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TRADITIONAL

APPROACHV = S+D

Ko = EBIT/V

Ke = EBIT- I/S

S = EBIT- I/ Ke


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EXAMPLE

Net operating income2,00,000

Total investment10,00,000

Equity capitalization rate:(a) If the firm uses no debt

10%

b If the firm uses Rs. 4 00 000


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MODIGILANI & MILLER

APPROACHIt does not agree with traditionalview. As per MM approach value of

firm depends upon the earningrather than the way in which theassets have been financed. MM

approach is identical with netoperating income ,if taxes areignored. it is identical with net

income approach, if taxes are


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ARBITRAGE PROCESS

This process involves purchasingsecurities whose prices are lower

and selling those securities whoseprices are higher in the relatedmarket.


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THANKS

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CAPITAL Sructure