Advanced financial

management
Corporate finance
Capital structure: capital structure
refers to the make-up of its
capitalization and it includes all long
term capital resources like
shares,loans,reserves and bonds
 Capitalization includes capital stock
and debt.
 Capitalization is the total accounting
value of the stock, surprises in
whatever form it may appear and
long term debt
 Essentials of an optimum capital
structure
 Flexibility
 Economy
 Solvency
 Efficiency
 Simplicity
 Safety
 control
 Determinants of capital structure
 Nature of business
 Stability of earning
 Growth rate
 Nature of investors
 ROI
 Trends in capital market
 Government regulations
 Capital structure decision
 In capital structure decision such
alternative should be selected which
will give the highest EPS/MPS as the
case may be.
 Theories of capital structure
 Net income approach
 Net operating income approach
 The traditional approach
 MM approach
 Net income approach: It states that a
firm can minimize the WACC and
increase the value of the firm as well
the market price of equity shares by
using debt financing to the maximum
possible extent
 Assumptions:
 The cost of debt is less than the cost
of equity
 there are no taxes
 The risk perceptions of the investors
is not changed by the use of debt.
 The increase in the debt financing in
the capital structure decreases the
proportion of equity capital and this
results in decrease in the WACC
resulting in an increase in the value
of the firm.
 The cost of debt is less that the cost
of equity because of two reasons :
 Debt involves less risk than equity
 Interest being a tax deductible
expenses
Net operating income approach
 Net operating income approach is
propounded by Durand.This theory is
diametrically opposite to the net
income approach theory.
 According to this theory changes in
the capital structure of a company
does not affect the market value of
the and the overall cost of capital
remains constant irrespective of the
method of financing. The Debt-equity
mix has no influence on the overall
cost of capital of the firm
 Assumptions
 The market capitalizes the value of
the firm as a whole
 The business risk remains constant
at every level of debt-equity mix.
 According to this theory with the
increased use of debt in the capital
structure it increases the financial
risk of the equity shareholders and
hence the cost of capital increases
 Traditional approach

 According to this approach the cost

of capital is not independent of the
capital structure of the firm and that
there is an optimal capital structure.
There are two types of risks
 Business risk
 Financial risk
 Assumption
 The capital structure of a firm consists of
only two kinds of capital debt and equity
shares
 The business risk of the company remains
constant overtime and is assumed to be
independent of its capital structure and
financial risk
 The firm has a perpetual life
 Corporate income tax does not exist
 Transaction costs are assumed to be
nil
 The operating income of the
company is assumed not to grow
over time
 The traditional theory states that the
financing pattern should include
moderate proportion of debt which
would result in safety to the creditors
claims as well as least cost
accounting
 Modigliani-Miller approach
 This approach states that the
average cost of capital of any firm is
independent of its capital structure
and equal to the capitalization rate
of pure equity streams of its class.
 The value of the firm and cost of
capital is the same for all the firms
irrespective of the proportion of debt
included in a firms capital structure.
 Assumptions
 All the firms in a class can be termed
as homogenous and placed in an
equvalent risk class.
 Capital markets are perfect and
investors are rational
 There does not exist ant transactions
cost
 The dividend payout ratio is 100
percent
 Criticisms
 Personal leverage is not equivalent
to corporate leverage
 Due to the capital market
imperfections the cost of borrowing
may be higher than for the
individual than for the corporate
 In the actual practice there are
transaction cost in the form of
brokerage,underwritting ,commission
etc.