V Capital structure refers to the combination or

mix of debt and equity which a company uses

to finance its long term operations. Capital in
this context refers to the permanent or long
term financing arrangements of the company.
Debt capital, therefore, is the company·s long
term borrowings and equity capital is the long
term funds provided by the shareholders or
owners of the company. In other words, in
capital structure it is decided that what portion
of the total required capital be raised from
shares and what portion from debentures.
V Capitalization is quantitative concept
indicating the total amount of long term
finance required to carry on the business.
Capital structure, on the other hand, is the
pattern of financing and is the process which
comes after determining capitalization. It
involves the issue of different types of
securities to raise the total amount of funds
required and the relative proportion of each
type of security.
V Capital structure is the permanent financing of
the company representing long term sources of
capital i.e. owner·s fund and long term debt but
excludes short term credit. Financial structure
refers to the way, the company·s assets are
financed. It is the entire left hand side of the
balance sheet which represents all the long
term and short term sources of capital. Thus,
capital structure is only a part of financial
structure.
 V There are two types of factors which affects the
capital structure of a company. They are:
1. Internal factors.
2. External factors.
1. Size of the business.
2. Nature of the business.
3. Regularity and certainty of income.
4. Assets structure.
5. Age of the firm.
6. Operating ratio.
7. Trading on equity.
1. Capital market conditions.
2. Nature of investors.
3. Statutory requirements.
4. Taxation policy.
5. Policies of financial institutions.
6. Cost of financing.
7. Seasonal variations.
V The optimal or the best capital structure
implies the most economical and safe ratio
between various types of securities. It may be
defined as that mix of debt and equity which
maximizes the value of the company and
minimizes the cost of capital.
1. Minimum cost of capital.
2. Minimum risk.
3. Maximum return.
4. Maximum control.
5. Simplicity.
6. Flexibility.
7. Alternative rules.
V The point of indifference refers to that earnings
before interest and tax (EBIT) level at which
earnings per share (EPS) remains the same
irrespective of difference alternatives of debt
equity mix. At this level of EBIT, the rate of
return on capital employed is equal to the cost
of debt and this is also known as break even
level of EBIT for alternative financial plans.
1. Net income theory.
2. Net operating income theory.
3. Traditional theory.
4. Modigliani miller theory.
V This theory was propounded by David Durand
and is also known as fixed Ke theory.
According to this theory a firm can increase the
value of the firm and reduce the overall cost of
capital by increasing the proportion of debt in
its capital structure to the maximum possible
extent. It is due to the fact that debt is,
generally a cheaper source of funds.
1. The cost of debt is cheaper than the cost of
equity.
2. Income tax has been ignored.
3. The cost of debt capital and cost of equity
capital remain constant.
V þnder NI Theory, the total value of a firm is
computed by adding the market value of debt
in the capitalized value of earnings available
for equity shareholders.
V Total value of firm= Market value of equity +
Market value of debt.
V This theory was also propounded by David
Durand which is quite opposite to the net
income theory. According to this theory, the
total market value of the firm is not affected by
the change in the capital structure and the
overall cost of capital remains fixed irrespective
of the debt equity mix. It means the overall cost
of capital or weighted average cost of capital
will remain the same whether the debt equity is
50:50 or 30:70 or 0:100.
1. The split of total capitalization between debt
and equity is not essential.
2. The equity shareholders and other investors
capitalizes the value of the firm as a whole.
3. The business risk at each level of debt equity
mix remains constant.
4. The debt capitalization rate is constant.
5. The corporate income tax does not exist.
V þnder this approach the total value of the firm
is computed by capitalizing the net operating
income by weighted average cost of capital or
overall cost of capital.
V This approach is intermediatery to net income
(NI) approach and operating income (NOI)
approach and hence it is also known as
intermediate approach propounded by Ezra
Soloman. Debt is a cheap source of raising
funds as compared to equity capital. therefore,
according to this approach, a firm can reduce
the overall cost of capital or increase the total
value of the firm by increasing the debt
proportion in its capital structure to a certain
limit.
V Franco modigliani and Merton miller theory is
identical with net operating income theory in
the absence of corporate taxes and net income
theory when corporate taxes exist.
1. Perfect capital market.
2. No transaction cost.
3. Homogeneous risk class.
4. Risk.
5. No corporate taxes.
 V Main sources of procurement of finance are of
two types which are as follows:
1. Sources of long term finance.
2. Sources of short term finance.
V _ong term financing means raising of funds for
long term i.e. a period exceeding five years and
is required to execute several projects relating
to improvement and development of existing
industries and establishing new industry.
V Short term financing means raising of funds for
a short term i.e. less than one year. Such
financing is required to meet the short term
working capital needs of the business. Short
term financing is of a self liquidating nature.
1. Equity shares.
2. Preference shares.
3. Debentures.
4. Term loan/ Institutional finance.
V Equity shares are those shares which carry no
preferential right in the payment of dividend
and refund of capital.
V An equity share is the existence of real
ownership and residual interest in the earnings
of the company.
V Equity shareholders bear the maximum risk
and therefore they control the affairs of the
company from legal point of view.
1. Risk capital.
2. þnstable dividend.
3. Variable market price.
4. Refund of capital.
5. Claims on assets.
6. Right to control.
1. Permanent capital.
2. Increased debt capacity.
3. No fixed burden.
4. Internal financing.
5. Cheap source of finance.
6. Right to participate in management.
7. Capital gain.
1. Dilution in control.
2. Over capitalization.
3. High cost.
4. þncertainty of income.
5. þnsuitable for non risky investors.
6. _oss on liquidation.
7. Right of control is a myth.
V A preference share is a share which carries
preferential right as to the payment of dividend
at a fixed rate either free or subject to income
tax and as to the payment of capital at the time
of liquidation prior to equity shareholders.
1. Claims of income.
2. Claims on assets.
3. No controlling power.
4. Hybrid security.
1. Cumulative and non cumulative.
2. Redeemable and irredeemable.
3. Participating and non participating.
4. Convertible and non convertible.
1. Wider market for raising capital.
2. Flexible capital structure.
3. No interference in management.
4. Regular fixed income.
5. Safety of capital.
1. Fixed burden.
2. More costly.
3. _oss to equity shareholders.
4. No voting rights.
5. No claim over surplus.
6. No capital gain.
V Debentures includes debenture stock, bonds or
any other securities of a company whether
constituting a charge on the assets of the
company or not.
V In fact, a debenture is an acknowledgement of
debt by a company. It is an instrument in
writing under which a company agrees to pay
a fixed rate of interest at a periodical intervals
and to repay the loan at the expiry of the
stipulated time.
1. Written acknowledgement of debt.
2. Refund of debt.
3. Claims on income.
4. Claims on assets.
5. Right to control.
1. Registered and Bearer debentures.
2. Redeemable and Irredeemable debentures.
3. Secured and unsecured debentures.
4. Convertible and non convertible debentures.
5. Guaranteed debentures.
6. Zero interest debentures.
7. Collateral debentures.
1. Capital from moderate investors.
2. Economy.
3. No interference in management.
4. Flexibility in capital structure.
5. Fixed and stable income.
6. Safety of investment.
7. _iquidity.
V Fixed burden.
V Reduction in credit worthiness.
V No extra profits.
V No voting rights.
1. IFCI
2. ICICI
3. IDBI
4. SIDBI
5. EXIM Bank
6. þTI
7. _IC
8. GIC
1. Public deposits.
2. Bank credit.
3. Trade credit.
4. Commercial paper.
5. Retained earnings.
6. Advances from customers.
V The term public deposit means any money
received by a non banking company by way of
deposits from the public including the
employees, customers and shareholders of the
company other than in the form of shares and
debentures. People preferred to deposit their
savings with the reputed business firms due to
the higher rate of interest offered by these firms
and the lack of faith in the banks.
1. _oans.
2. Cash credit.
3. Overdraft.
4. Discounting of bills.
5. _etter of credit.
 V Trade credit is the principal source of short
term finance. It is the credit extended by one
business firm to another as incidental to sale or
purchase of goods and services.
V Generally, there are three categories of trade
credit:
1. Open account.
2. Bills of exchange.
3. Promissory notes.
V Commercial paper is an unsecured promissory
note payable to the bearer and issued by
business firms for a definite period (normally 7
to 90 days) based on discount, to raise short
term funds.
V Thus, commercial paper is a certificate of
unsecured loan for a short period. But, only
large companies enjoying high credit rating
and sound financial position can issue
commercial paper to raise funds because RBI
has laid down a number of conditions to
determine eligibility of a company for the issue
V Ploughing back of profits is a technique of
financial management under which all profits
of a company are not distributed amongst the
shareholders as dividend, but a part of the
profits is retained or reinvested in the
business.
V This source of financing can be compared with
the habit of an Indian women who saves from
her husband·s income for bad days and it is
used when the family has no other option.
V In certain cases, manufacturers or suppliers of
goods require from the customers to make an
advance before the delivery of goods. This
amount remains with the supplier till the
delivery of goods. Thus, advance from
customers is a cheap source of short term
financing. This facility is available in case of
products which are in short supply or which
invite a waiting period for delivery.
V Financial planning means deciding in advance
the financial activities to be carried on to
achieve the basic objectives of the firm. The
basic objective of the firm is to earn maximum
profits out of minimum efforts or to maximize
the wealth of the shareholders in efficient
manner. So, the basic purpose of financial
planning is to make sure that adequate funds
are raised at the minimum cost and that these
funds are used wisely.
V In other words, financial planning may be
defined as a process of decision making
1. Determining financial objectives.
2. Formulating financial policies.
3. Developing financial procedures.
1. _ong term financial planning.
2. Medium term financial planning.
3. Short term financial planning.
1. Historical analysis.
2. Identifying the long term needs.
3. Identifying the sources of funds.
4. Analysis of the operational activities.
5. Harmony among different plans.
1. Simplicity.
2. Foresightedness.
3. Optimum use of funds.
4. Flexibility.
5. _iquidity.
6. Provision for contingencies.
7. Economy.
1. Nature of industry.
2. Size of business unit.
3. Quantum of risk.
4. Appraisal of alternative sources of finance.
5. Attitude of management.
6. Statutory control.
7. External factors.
1. Availability of capital at minimum cost.
2. Optimum capital structure.
3. Conservation of capital.
4. Replacement of obsolete assets.
5. Adequate liquidity.
6. Higher return on capital employed.
1. _imitations of forecasting.
2. _ack of coordination.
3. Rigidity.