The document discusses capital structure, which refers to the composition of a company's long-term capital from sources like loans, reserves, shares, and bonds. It also discusses capitalization, which is the total amount of securities issued, and financial structure, which includes all short-term and long-term financial resources. Different approaches to capital structure are described, including the net income approach, which argues the optimal structure is maximum debt financing to reduce costs. The net operating income approach argues structure does not impact value or costs. The traditional approach finds an optimal debt ratio that balances lower debt costs and higher equity costs.

2.  Capital structure of a
company refers to the
composition or make-up of
its capitalization and it
includes all long term
capital resources viz :-
loans, reserves, shares and
bonds.
 The capital structure is
made up of debt and equity
securities and refers to
permanent financing of a
firm.

3. Capitalization, capital structure, financial
structure
 Capitalization refers to the total amount of securities
issued by a company while capital structure refers to
the kinds of securities and the proportionate amounts
that make up capitalization.
 Financial structure refers to all the financial resources
marshaled by the firm, short term as well as long term
and all forms of debt as well as equity.
 Thus, financial structure generally is composed of a
specified percentage of short term debt, long term
debt and shareholder’s funds.

4. Illustration :
Information about a certain company is given as follows:
• Liabilities:
• Equity share capital 10,00,000
• Preference share capital 5,00,000
• Long term loans and debentures 2,00,000
• Retained earnings 6,00,000
• Capital surplus 50,000
• Current liabilities 1,50,000
25,00,000
Solution
Here, capitalization would mean the total amount of securities issued by
a company:
• Equity share capital 10,00,000
• Preference share capital 5,00,000
• Long term loans and debentures 2,00,000
• Capitalization 17,00,000

5. Capital structure refers to the proportionate amount that makes up the
capitalization.
proportion
• Equity share capital 1,00,000 58.82%
• Preference share capital 5,00,000 29.41%
• Long term loans and debentures 2,00,000 11.77%
• 17,00,000 100%
Financial structure refers to all the financial resources short as well as long term and
is:
proportion
Proportionate amount
• Equity share capital 10,00,000 40%
• Preference share capital 5,00,000 20%
• Long term loans and debentures 2,00,000 8%
• Retained earnings 6,00,000 24%
• Capital surplus 50,000 2%
• Current liabilities 1,50,000 6%
25,00,000 100%

6. Theories of capital structure
The important theories of capital structure are:
 Net income approach
 Net operating income approach
 The traditional approach
 Modigliani and Miller approach

7. Net income approach
 According to this approach, a firm can minimize the
weighted average cost of capital and increase the value of
the firm as well as market price of equity shares by using
debt financing to the maximum possible extent.
 A company can increase its value and decrease its overall
cost of capital by increasing the proportion of debt in its
capital structure.
 The proportion of debt financing in capital structure
increases due to which the proportion of a less expensive
source of funds increases. This results in the decrease in
overall cost of capital leading to an increase in the value of
the firm.

8.  Total market value of a firm on this basis :
V=S+D
Where, V = total market value of the firm
S = market value of equity shares
= earnings available to equity share holders
Equity capitalization rate
And D = market value of debt
 Overall cost of capital :-
K0 = EBIT
V

9. Illustration:
X ltd is expecting an annual EBIT of 1,00,000. The company has 4 lakh in
10% debentures. The cost of equity capital or the capitalization rate is
12.5%. you are required to calculate the total value of the firm
according to the net income approach.
Solution:-
• Net income (EBIT) 1,00,000
• Less : interest on 10% debentures of 4,00,000 40,000
• Earnings available to equity shareholders 60,000
• Market capitalization rate 12.5%
• Market value of equity shares(s) 4,80,000
60,000 * 100/12.5
• Market value of debentures(D) 4,00,000
• Value of the firm (S+D) 8,80,000

10. Net operating income approach
 It is another extreme of the effect of leverage on the
value of the firm. It is opposite to the net income
approach.
 According to this approach, change in the capital
structure of a company does not affect the market
value of the firm and the overall cost of capital remains
constant irrespective of the method of financing. It
implies that the overall cost of capital remains
constant whether the debt-equity mix is 50:50 or 0:100.

11.  The reasons for such assumptions are that the
increased use of debt increases the financial risk of the
equity shareholders and hence the cost of equity
increases.
 On the other hand, the cost of debt remains constant
with the increasing proportion of debt as the financial
risk of the lenders is not affected. Thus, the advantage
of using the cheaper source of funds i.e. debt is exactly
offset by the increased cost of equity.

12.  The net operating income approach shows the effect of
leverage on the overall cost of capital and has been
presented as :-
V = EBIT
KO
Where, V = value of the firm
ko = overall cost of capital
 market value of equity here is the residual value which
is determined by deducting the market value of
debentures from the total market value of the firm.
S = V – D
Where, S = market value of equity shares,
V= market value of the firm, D = market value of debt.

13. Illustration:
A company expects a net operating income of 1,00,000. It has 5,00,000, 6%
debentures. The overall capitalization rate is 10%. Calculate the value of
the firm and the equity capitalization rate(cost of equity) according to the
net operating income approach.
Solution:-
• Net operating income = 1,00,000
• Overall cost of capital = 10%
• Market value of the firm (V) = EBIT(net operating income)/overall cost of
capital(ko)
1,00,000* 100/10 = 10,00,000
• Market value of the firm = 10,00,000
• Less : market value of debentures = 5,00,000
• Total market value of equity = 5,00,000
Equity capitalization rate ( cost of equity ) :- (ke)
Earnings available to equity shareholders/ Total market value of equity
shares
= (1,00,000-30,000)/ (1,00,000-5,00,000) *100
= 14%

14. Traditional approach
 The traditional approach also known as intermediate
approach, is a compromise between the two extremes
of net income approach and net operating income
approach.
 . According to this theory, the value of the firm can be
increased initially or the cost of capital can be
decreased by using more debt as the debt is a cheaper
source of funds than equity.
 Beyond a particular point, the cost of equity increases
because increased debt increases the financial risk of
the equity shareholders. The advantage of cheaper
debt at this point of capital structure is offset by
increased cost of equity.

15.  After this there comes a stage, when the increased cost
of equity cannot be offset by the advantage of low-cost
debt. Thus, overall cost of capital, according to this
approach, decreases up to a certain point, remains
more or less unchanged and increases or rises beyond
a certain period.

16. Illustration :
Compute the market value of a firm, value of shares and the average
cost of capital from the following information :
• Net operating income 2,00,000
• Total investment 10,00,000
• Equity capitalization rate
• If the firm uses no debt 10%
• If the firm uses 4,00,000 debt 11%
• If the firm uses 6,00,000 debt 13%
Assume that 4,00,000 debentures can be raised at 5% rate whereas
6,00,000 debentures can be raised at 6% rate of interest.

17. Solution:
Computation of market value of firm, value of shares & average cost of capital
(a) No debt (b)4,00,000 deb @ 5% (c) 6,00,000
deb @ 6%
• Net operating income 2,00,000 2,00,000 2,00,000
• Less : interest 20,000 36,000
(cost of debt)
• Earnings 2,00,000 1,80,000 1,64,000
available to equity shldr.
equity capitalization rate 10% 11% 13%
• Market value of shares 2,00,000*100/10 1,80,000*100/11 1,64,000*100/13
= 20,00,000 = 16,36,363 = 12,61,538
• market value of debt NIL 4,00,000 6,00,000
• market value of the firm 20,00,000 20,36,363 18,61,538
• average cost of capital or: 2k/20k 2k/20,36,363 2k/18,61,538
• Earnings/value of the firm *100 *100 *100
• EBIT/V 10% 9.8% 10.7%