Capital structure:

The capital structure of a business is the mix of types of debt and equity the
company has on its balance sheet. It allows a firm to understand what kind of
funding the company uses to finance its overall activities and growth. In other
words, it shows the proportions of debt and equity in the funding.
The capital structure decision can affect the value of the firm either by changing
the expected earnings or the cost of capital or both.
The objective of the firm should be directed towards the maximization of the value
of the firm the capital structure, or average, decision should be examined from the
point of view of its impact on the value of the firm.
If the value of the firm can be affected by capital structure or financing decision a
firm would like to have a capital structure which maximizes the market value of the
firm. The capital structure decision can affect the value of the firm either by
changing the expected earnings or the cost of capital or both.
If average affects the cost of capital and the value of the firm, an optimum capital
structure would be obtained at that combination of debt and equity that maximizes
the total value of the firm (value of shares plus value of debt) or minimizes the
weighted average cost of capital.
Definition of Capital Structure:
Capital structure is the mix of the long-term sources of funds used by a firm. It is
made up of debt and equity securities and refers to permanent financing of a firm. It
is composed of long-term debt, preference share capital and shareholders funds.
Various authors have defined capital structure in different ways.
Some of the important definitions are presented below:
According to Gerestenberg, 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. Keown et al. defined capital
structure as, balancing the array of funds sources in a proper manner, i.e. in
relative magnitude or in proportions.
In the words of P. Chandra, capital structure is essentially concerned with how the
firm decides to divide its cash flows into two broad components, a fixed component
that is earmarked to meet the obligations toward debt capital and a residual
component that belongs to equity shareholders.
Hence capital structure implies the composition of funds raised from various sources
broadly classified as debt and equity. It may be defined as the proportion of debt
and equity in the total capital that will remain invested in a business over a long
period of time. Capital structure is concerned with the quantitative aspect. A

decision about the proportion among these types of securities refers to the capital
structure decision of an enterprise.
Importance of Capital Structure:
Decisions relating to financing the assets of a firm are very crucial in every business
and the finance manager is often caught in the dilemma of what the optimum
proportion of debt and equity should be. As a general rule there should be a proper
mix of debt and equity capital in financing the firms assets. Capital structure is
usually designed to serve the interest of the equity shareholders.
Therefore instead of collecting the entire fund from shareholders a portion of long
term fund may be raised as loan in the form of debenture or bond by paying a fixed
annual charge. Though these payments are considered as expenses to an entity,
such method of financing is adopted to serve the interest of the ordinary shareholders in a better way.
The importance of designing a proper capital structure is explained below:
Value Maximization:
Capital structure maximizes the market value of a firm, i.e. in a firm having a
properly designed capital structure the aggregate value of the claims and ownership
interests of the shareholders are maximized.

Cost Minimization:
Capital structure minimizes the firms cost of capital or cost of financing. By
determining a proper mix of fund sources, a firm can keep the overall cost of capital
to the lowest.
Increase in Share Price:
Capital structure maximizes the companys market price of share by increasing
earnings per share of the ordinary shareholders. It also increases dividend receipt of
the shareholders.
Investment Opportunity:
Capital structure increases the ability of the company to find new wealth- creating
investment opportunities. With proper capital gearing it also increases the
confidence of suppliers of debt.
Growth of the Country:
Capital structure increases the countrys rate of investment and growth by
increasing the firms opportunity to engage in future wealth-creating investments.

Patterns of Capital Structure:

There are usually two sources of funds used by a firm: Debt and equity. A new
company cannot collect sufficient funds as per their requirements as it has yet to
establish its creditworthiness in the market; consequently they have to depend only
on equity shares, which is the simple type of capital structure. After establishing its
creditworthiness in the market, its capital structure gradually becomes complex.

A complex capital structure pattern may be of following forms:

i. Equity Shares and Debentures (i.e. long term debt including Bonds etc.),
ii. Equity Shares and Preference Shares,
iii. Equity Shares, Preference Shares and Debentures (i.e. long term debt including
Bonds etc.).
However, irrespective of the pattern of the capital structure, a firm must try to
maximize the earnings per share for the equity shareholders and also the value of
the firm.
Assumptions:
Generally, the capital structure theories have the following assumptions.
There are no corporate taxes (this assumption has been removed later).
1. The firms use only 2 sources of financing namely perpetual debts ad
equity shares.
2. The firms pay 100% of the earnings as dividend. This means that the
dividend pay-out ratio is 100% and there are no earnings that are retained
by the firms.
3. The total assets are given which do not change and the investment
decisions are assumed to be constant.
4. Business risk is constant over time and it is assumed that it is
independent of the capital structure.
5. The firm has a perpetual life.
6. The firms earnings before interest and taxes are not expected to grow.
7. The firms total financing remains constant.
8. The firms degree of leverage can be altered either by selling shares and to
retire the debt using the proceeds or by raising more debt and reduce the
equity financing.
9. All the investors are assumed to have the same subjective probability
distribution of the future expected operating profits for a given firm.
The above assumptions and definitions described above are valid under any of
the capital structure theories. David Durand views, Traditional view and MM
Hypothesis are tine important theories on capital structure.

1. David Durand views:

The existence of an optimum capital structure is not accepted by all. There exist
two extreme views and a middle position. David Durand identified the two
extreme views the Net income and net operating approaches.

a) Net income Approach (Nl):

Under the net income (Nl) approach, the cost of debt and cost of equity are
assumed to be independent of the capital structure. The weighted average cost
of capital declines and the total value of the firm rise with increased use of
average.

b) Net Operating income Approach (NOI):

Under the net operating income (NOI) approach, the cost of equity is assumed to
increase linearly with average. As a result, the weighted average cost of capital
remains constant and the total of the firm also remains constant as average
changed.
Thus, if the Nl approach is valid, average is a significant variable and financing
decisions have an important effect on the value of the firm, on the other hand, if
the NOI approach is correct, then the financing decision should not be of greater
concern to the financial manager, as it does not matter in the valuation of the
firm.

2. Traditional view:
The traditional view is a compromise between the net income approach and the
net operating approach. According to this view, the value of the firm can be
increased or the cost, of capital can be reduced by the judicious mix of debt and
equity capital.
This approach very clearly implies that the cost of capital decreases within the
reasonable limit of debt and then increases with average. Thus an optimum
capital structure exists and occurs when the cost of capital is minimum or the
value of the firm is maximum.
The cost of capital declines with leverage because debt capital is chipper than
equity capital within reasonable, or acceptable, limit of debt. The weighted
average cost of capital will decrease with the use of debt. According to the
traditional position, the manner in which the overall cost of capital reacts to
changes in capital structure can be divided into three stages and this can be
seen in the following figure.

Criticism:
1. The traditional view is criticised because it implies that totality of risk incurred by
all security-holders of a firm can be altered by changing the way in which this
totality of risk is distributed among the various classes of securities.
2. Modigliani and Miller also do not agree with the traditional view. They criticise the
assumption that the cost of equity remains unaffected by leverage up to some
reasonable limit.

3. MM Hypothesis:
The Modigliani Miller Hypothesis is identical with the net operating income
approach, Modigliani and Miller (M.M) argue that, in the absence of taxes, a firms
market value and the cost of capital remain invariant to the capital structure
changes.

Assumptions:

The M.M. hypothesis can be best explained in terms of two propositions.

It should however, be noticed that their propositions are based on the
following assumptions:
1. The securities are traded in the perfect market situation.
2. Firms can be grouped into homogeneous risk classes.
3. The expected NOI is a random variable
4. Firm distribute all net earnings to the shareholders.
5. No corporate income taxes exist.

Proposition I:
Given the above stated assumptions, M-M argue that, for firms in the same risk
class, the total market value is independent of the debt equity combination and is
given by capitalizing the expected net operating income by the rate appropriate to
that risk class.
This is their proposition I and can be expressed as follows:

According to this proposition the average cost of capital is a constant and is not
affected by leverage.

Arbitrary-process:
M-M opinion is that if two identical firms, except for the degree of leverage, have
different market values or the costs of capital, arbitrary will take place to enable
investors to engage in personal leverage as against the corporate leverage to
restore equilibrium in the market.
Proposition II: It defines the cost of equity, follows from their proposition, and
derived a formula as follows:

Ke = Ko + (Ko-Kd) B/S
The above equation states that, for any firm in a given risk class, the cost of equity
(Ke) is equal to the constant average cost of capital (K o) plus a premium for the
financial, risk, which, is equal to debt-equity ratio times the spread between the
constant average of capita and the cost of debt, (K o-Kd) B/S.
The crucial part of the M-M hypothesis is that K e will not rise even if very excessive
raise of leverage is made. This conclusion could be valid if the cost of borrowings, K d
remains constant for any degree of leverage. But in practice K d increases with
leverage beyond a certain acceptable, or reasonable, level of debt.
However, M-M maintain that even if the cost of debt, K d, is increasing, the weighted
average cost of capital, Ko, will remain constant. They argue that when K d increases,
Ke will increase at a decreasing rate and may even turn down eventually. This is
illustrated in the following figure.

1. A company's expected annual net operating income (EBIT) is $ 50,000. The

company has $ 2,00,000, 10% debentures. The equity capitalization rate (ke)
of the company is 12.5 per cent.
2. From the following information, calculate the value of the company and
overall cost of capital.
Earnings before Interest Tax (EBIT)

100,000

Bonds (Debt part)

300,000

Cost of Bonds issued (Debt)

10%

WACC

12.5%

a. Assume that the proportion of debt increases from 300,000 to 400,000 and
everything else remains same. What is the value of the company and overall
cost of capital?
3. A
1. Old School Corporation expects an EBIT of Rs.9, 000 every year forever. Old
School currently has no debt, and its cost of equity is 17%. The firm can
borrow at 10%. If the corporate tax rate is 35%, what is the value of the firm?
What will be the value of Old School if it converts to 50% debt? To 100%
debt?
Working capital:
The uses of funds of a concern can be divided into two parts namely longterm funds and short-term funds. The long term investment may be termed
as fixed investment. A major part of the long-term funds is invested in the
fixed assets. These fixed assets are retained in the business to earn profits
during the life of the fixed assets. To run the business operations shortterm
assets are also required. The term working capital is commonly used for the
capital required for day-to-day working in a business concern, such as for
purchasing raw material, for meeting day-to-day expenditure on salaries,
wages, rents rates, advertising etc. But there are much disagreement among
various financial authorities (Financiers, accountants, businessmen and
economists) as to the exact meaning of the term working capital.
Definition and classification of working capital:
Working capital refers to the circulating capital required to meet the day to
day operations of a business firm. Working capital may be defined by various
authors as follows:
1. According to Weston & Brigham - Working capital refers to a firms
investment in short term assets, such as cash amounts receivables,
inventories etc.
2. Working capital means current assets. Mead, Baker and Malott
3. The sum of the current assets is the working capital of the business
J.S.Mill
Working capital is defined as the excess of current assets over current
liabilities and provisions. But as per accounting terminology, it is difference
between the inflow and outflow of funds. In the Annual Survey of Industries

(1961), working capital is defined to include Stocks of materials, fuels, semifinished goods including work-in-progress and finished goods and byproducts; cash in hand and bank and the algebraic sum of sundry creditors as
represented by
(a) Outstanding factory payments e.g. rent, wages, interest and dividend;
(b) Purchase of goods and services;
(c) Short-term loans, advances, sundry debtors comprising amounts due to
the factory on account of sale of goods, services and advances towards tax
payments.
The term working capital is often referred to circulating capital which is
frequently used to denote those assets which are changed with relative
speed from one form to another i.e., starting from cash, changing to raw
materials, converting into work-in-progress and finished products, sale of
finished products and ending with realization of cash from debtors. Working
capital has been described as the life blood of any business which is apt
because it constitutes a cyclically flowing stream through the business.
CONCEPTS OF WORKING CAPITAL
There are two concepts of working capital viz. quantitative and qualitative.
Some people also define the two concepts as gross concept and net concept.
According to quantitative concept, the amount of working capital refers to
total of current assets. Current assets are considered to be gross working
capital in this concept. The qualitative concept gives an idea regarding source
of financing capital. According to qualitative concept the amount of working
capital refers to excess of current assets over current liabilities.
L.J. Guthmann defined working capital as the portion of a firms current
assets which are financed from longterm funds.
The excess of current assets over current liabilities is termed as Net working
capital. In this concept Net working capital represents the amount of
current assets which would remain if all current liabilities were paid. Both the
concepts of working capital have their own points of importance. If the
objectives is to measure the size and extent to which current assets are being
used, Gross concept is useful; whereas in evaluating the liquidity position of
an undertaking Net concept becomes pertinent and preferable. It is
necessary to understand the meaning of current assets and current liabilities
for learning the meaning of working capital, which is explained below.

Current assets It is rightly observed that Current assets have a short life
span. These types of assets are engaged in current operation of a business
and normally used for short term operations of the firm during an accounting
period i.e. within twelve months. The two important characteristics of such
assets are,
(i)

Short life span, and

(ii)

(ii) Swift transformation into other form of assets.

Cash balance may be held idle for a week or two; account receivable may
have a life span of 30 to 60 days, and inventories may be held for 30 to 100
days.
Fitzgerald defined current assets as, cash and other assets which are
expected to be converted in to cash in the ordinary course of business within
one year or within such longer period as constitutes the normal operating
cycle of a business.
Current liabilities The firm creates a Current Liability towards creditors
(sellers) from whom it has purchased raw materials on credit. This liability is
also known as accounts payable and shown in the balance sheet till the
payment has been made to the creditors.
The claims or obligations which are normally expected to mature for payment
within an accounting cycle are known as current liabilities. These can be
defined as those liabilities where liquidation is reasonably expected to
require the use of existing resources properly classifiable as current assets, or
the creation of other current assets, or the creation of other current
liabilities. Circulating capital working capital is also known as circulating
capital or current capital. The use of the term circulating capital instead of
working capital indicates that its flow is circular in nature.
STRUCTURE OF WORKING CAPITAL
The different elements or components of current assets and current liabilities
constitute the structure of working capital which can be illustrated in the
shape of a chart as follows:
STRUCTURE OF CURRENT ASSETS AND CURRENT LIABILITIES
Current Liabilities Current Assets Bank Overdraft Cash and Bank Balance
Creditors Inventories: Raw-Materials Work-in-progress Finished Goods
Outstanding Expenses Spare Parts Bills Payable Accounts Receivables Short-

term Loans Bills Receivables Proposed Dividends Accrued Income Provision

for Taxation, etc Prepaid Expenses Short-term Investments
CIRCULATION OF WORKING CAPITAL
At one given time both the current assets and current liabilities exist in the
business. The current assets and current liabilities are flowing round in a
business like an electric current. However, The working capital plays the
same role in the business as the role of heart in human body. Working capital
funds are generated and these funds are circulated in the business. As and
when this circulation stops, the business becomes lifeless. It is because of
this reason that he working capital is known as the circulating capital as it
circulates in the business just like blood in the human body.
1. Gross Working Capital: It refers to the firms investment in total current or
circulating assets.
2. Net Working Capital: The term Net Working Capital has been defined in
two different ways:
i. It is the excess of current assets over current liabilities. This is, as a
matter of fact, the most commonly accepted definition. Some people define it
as only the difference between current assets and current liabilities. The
former seems to be a better definition as compared to the latter.
ii. It is that portion of a firms current assets which is financed by longterm funds.
3. Permanent Working Capital: This refers to that minimum amount of
investment in all current assets which is required at all times to carry out
minimum level of business activities. In other words, it represents the current
assets required on a continuing basis over the entire year. Tandon Committee
has referred to this type of working capital as Core current assets. Working
Capital may be classified in two ways (Kinds of Working Capital)
a) Concept based working capital
b) Time based working capital
c) Classification on the basis of financial reports.
CONCEPT BASED WORKING CAPITAL
1. Gross Working Capital

2. Net Working Capital

3. Negative Working Capital
CONCEPTS OF WORKING CAPITAL
1. Gross Working Capital: It refers to the firms investment in total
current or circulating assets.
2. Net Working Capital: The term Net Working Capital has been
defined in two different ways:
i. It is the excess of current assets over current liabilities. This is, as a
matter of fact, the most commonly accepted definition. Some people define it
as only the difference between current assets and current liabilities. The
former seems to be a better definition as compared to the latter.
ii. It is that portion of a firms current assets which is financed by longterm funds. 3. Negative Working Capital: This situation occurs when the
current liabilities exceed the current assets. It is an indication of crisis to the
firm.
TIME BASED WORKING CAPITAL
1. Permanent or Fixed Working Capital
(a) Regular Working Capital
(b) Reserve Working Capital
2. Temporary or Variable Working Capital
(a) Seasonal Working Capital
(b) Special Working Capital
1. Permanent Working Capital: This refers to that minimum amount of
investment in all current assets which is required at all times to carry out
minimum level of business activities. In other words, it represents the current
assets required on a continuing basis over the entire year. Tandon Committee
has referred to this type of working capital as Core current assets. The
following are the characteristics of this type of working capital:
2. Hi-tech Ltd. plans to sell 30,000 units next year. The expected cost of goods
sold is as follows:

Rs. (Per Unit)

Raw material
Manufacturing expenses

100
30

Selling, administration and financial expenses

Selling price

20

200

The duration at various stages of the operating cycle is expected to be as

follows:
Raw material stage

2 months

Work-in-progress stage

1 month

Finished stage

1/2 month

Debtors stage

1 month

Assuming the monthly sales level of 2,500 units, estimate the gross
working capital requirement. Desired cash balance is 5% of the gross working
capital requirement, and working- progress in 25% complete with respect to
manufacturing expenses.
3. Calculate the amount of working capital requirement for SRCC Ltd. from the
following information: .
(Per Unit)
Raw materials

160

Direct labour

60

Overheads

120

Total cost

340

Profit

60

Selling price

400

Raw materials are held in stock on an average for one month. Materials are in
process on an average for half-a-month. Finished goods are in stock on an
average for one month. Credit allowed by suppliers is one month and credit
allowed to debtors is two months. Time lag in payment of wages is 1 weeks.
Time lag in payment of overhead expenses is one month.
One fourth of the sales are made on cash basis.

Cash in hand and at the bank is expected to be Rs. 50,000; and expected
level of production Cash in hand and at the bank is expected to be Rs.
50,000; and expected level of production amounts to 1,04,000 units for a
year of 52 weeks.
You may assume that production is carried on evenly throughout the year and
a time period of four weeks is equivalent to a month.

4. JBC Ltd. sells goods on a gross profit of 25%. Depreciation is considered as a

part of cost of production. The following are the annual figures given to you :
Rs.
Sales (2 months credit)

18,00,000

Materials consumed (1 months credit)

4,50,000

Wages paid (1 month lag in payment)

3,60,000

Cash manufacturing expenses (1 month lag in payment)

Administrative expenses (1 month lag in payment)
Sales promotion expenses (paid quarterly in advance)

4,80,000
1,20,000
60,000

The company keeps one months stock each of raw materials and finished
goods. It also keeps Rs. 1,00,000 in cash. You are required to estimate the
working capital requirements of the company on cash cost basis, assuming
15% safety margin.