Financing Decisions: Capital Structure | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS 
 CAPITAL STRUCTURE 
 
 
? State the meaning and significance of capital structure. 
? Discuss the various capital structure theories i.e. Net Income 
Approach, Traditional Approach, Net Operating Income (NOI) 
Approach, Modigliani and Miller (MM) Approach, Trade- off 
Theory and Pecking Order Theory. 
? Describe concepts and factors for designing an optimal 
capital structure. 
? Discuss essential features of capital structure of an entity. 
? Discuss optimal capital structure. 
? Analyse the relationship between the performance of a 
company and its impact on the earnings of the shareholders 
i.e. EBIT-EPS analysis. 
? Discuss the meaning, causes and consequences of over and 
under capitalisation to an entity. 
CHAPTER 
5 
Page 2


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS 
 CAPITAL STRUCTURE 
 
 
? State the meaning and significance of capital structure. 
? Discuss the various capital structure theories i.e. Net Income 
Approach, Traditional Approach, Net Operating Income (NOI) 
Approach, Modigliani and Miller (MM) Approach, Trade- off 
Theory and Pecking Order Theory. 
? Describe concepts and factors for designing an optimal 
capital structure. 
? Discuss essential features of capital structure of an entity. 
? Discuss optimal capital structure. 
? Analyse the relationship between the performance of a 
company and its impact on the earnings of the shareholders 
i.e. EBIT-EPS analysis. 
? Discuss the meaning, causes and consequences of over and 
under capitalisation to an entity. 
CHAPTER 
5 
 
 
5.2 FINANCIAL MANAGEMENT  
 
 5.1 MEANING OF CAPITAL STRUCTURE 
Capital structure is the combination of capitals from different sources of finance. 
The capital of a company consists of equity share holders’ fund, preference share 
capital and long term external debts. The source and quantum of capital is decided 
keeping in mind following factors: 
1. Control: capital structure should be designed in such a manner that existing 
shareholders continue to hold majority stake.   
2. Risk: capital structure should be designed in such a manner that financial risk 
of the company does not increases beyond tolerable limit. 
3. Cost: overall cost of capital remains minimum. 
Capital Structure Decision
Capital Structure Theories
? Net Income (NI) Approach 
? Traditional Approach
? Net Operating Income(NOI)
Approach
? Modigliani- Miller (MM)
Approach
? Trade-off Theory
? Pecking Order Theory
Designing an Optimal Capital Structure
EBIT- EPS Analysis
 
Page 3


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS 
 CAPITAL STRUCTURE 
 
 
? State the meaning and significance of capital structure. 
? Discuss the various capital structure theories i.e. Net Income 
Approach, Traditional Approach, Net Operating Income (NOI) 
Approach, Modigliani and Miller (MM) Approach, Trade- off 
Theory and Pecking Order Theory. 
? Describe concepts and factors for designing an optimal 
capital structure. 
? Discuss essential features of capital structure of an entity. 
? Discuss optimal capital structure. 
? Analyse the relationship between the performance of a 
company and its impact on the earnings of the shareholders 
i.e. EBIT-EPS analysis. 
? Discuss the meaning, causes and consequences of over and 
under capitalisation to an entity. 
CHAPTER 
5 
 
 
5.2 FINANCIAL MANAGEMENT  
 
 5.1 MEANING OF CAPITAL STRUCTURE 
Capital structure is the combination of capitals from different sources of finance. 
The capital of a company consists of equity share holders’ fund, preference share 
capital and long term external debts. The source and quantum of capital is decided 
keeping in mind following factors: 
1. Control: capital structure should be designed in such a manner that existing 
shareholders continue to hold majority stake.   
2. Risk: capital structure should be designed in such a manner that financial risk 
of the company does not increases beyond tolerable limit. 
3. Cost: overall cost of capital remains minimum. 
Capital Structure Decision
Capital Structure Theories
? Net Income (NI) Approach 
? Traditional Approach
? Net Operating Income(NOI)
Approach
? Modigliani- Miller (MM)
Approach
? Trade-off Theory
? Pecking Order Theory
Designing an Optimal Capital Structure
EBIT- EPS Analysis
 
 
 
 5.3 
 
FINANCING DECISIONS – CAPITAL STRUCTURE 
Practically, it is difficult to achieve all of the above three goals together, hence, a 
finance manager has to make a balance among these three objectives.  
However, the objective of a company is to maximise the value of the company and 
it is prime objective while deciding the optimal capital structure. Capital Structure 
decision refers to deciding the forms of financing (which sources to be tapped); 
their actual requirements (amount to be funded) and their relative proportions 
(mix) in total capitalisation.  
Value of the firm =
EBIT
Overall cost of capital / Weighted average cost of capital
 
K o = (Cost of debt × weight of debt) + (Cost of equity × weight of equity) 
K o = [{K d × D/ (D+S)} + {K e × S/(D+S)}] 
Where:  
? K o is the weighted average cost of capital (WACC) 
? K d is the cost of debt 
? D is the market value of debt 
? S is the market value of equity 
? K e is the cost of equity  
Capital structure decision will decide weight of debt and equity and ultimately 
overall cost of capital as well as Value of the firm. So capital structure is relevant in 
maximizing value of the firm and minimizing overall cost of capital. 
Whenever funds are to be raised to finance investments, capital structure decision 
is involved. A demand for raising funds generates a new capital structure since a 
decision has to be made as to the quantity and forms of financing. The process of 
financing or capital structure decision is depicted in the figure below. 
Page 4


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS 
 CAPITAL STRUCTURE 
 
 
? State the meaning and significance of capital structure. 
? Discuss the various capital structure theories i.e. Net Income 
Approach, Traditional Approach, Net Operating Income (NOI) 
Approach, Modigliani and Miller (MM) Approach, Trade- off 
Theory and Pecking Order Theory. 
? Describe concepts and factors for designing an optimal 
capital structure. 
? Discuss essential features of capital structure of an entity. 
? Discuss optimal capital structure. 
? Analyse the relationship between the performance of a 
company and its impact on the earnings of the shareholders 
i.e. EBIT-EPS analysis. 
? Discuss the meaning, causes and consequences of over and 
under capitalisation to an entity. 
CHAPTER 
5 
 
 
5.2 FINANCIAL MANAGEMENT  
 
 5.1 MEANING OF CAPITAL STRUCTURE 
Capital structure is the combination of capitals from different sources of finance. 
The capital of a company consists of equity share holders’ fund, preference share 
capital and long term external debts. The source and quantum of capital is decided 
keeping in mind following factors: 
1. Control: capital structure should be designed in such a manner that existing 
shareholders continue to hold majority stake.   
2. Risk: capital structure should be designed in such a manner that financial risk 
of the company does not increases beyond tolerable limit. 
3. Cost: overall cost of capital remains minimum. 
Capital Structure Decision
Capital Structure Theories
? Net Income (NI) Approach 
? Traditional Approach
? Net Operating Income(NOI)
Approach
? Modigliani- Miller (MM)
Approach
? Trade-off Theory
? Pecking Order Theory
Designing an Optimal Capital Structure
EBIT- EPS Analysis
 
 
 
 5.3 
 
FINANCING DECISIONS – CAPITAL STRUCTURE 
Practically, it is difficult to achieve all of the above three goals together, hence, a 
finance manager has to make a balance among these three objectives.  
However, the objective of a company is to maximise the value of the company and 
it is prime objective while deciding the optimal capital structure. Capital Structure 
decision refers to deciding the forms of financing (which sources to be tapped); 
their actual requirements (amount to be funded) and their relative proportions 
(mix) in total capitalisation.  
Value of the firm =
EBIT
Overall cost of capital / Weighted average cost of capital
 
K o = (Cost of debt × weight of debt) + (Cost of equity × weight of equity) 
K o = [{K d × D/ (D+S)} + {K e × S/(D+S)}] 
Where:  
? K o is the weighted average cost of capital (WACC) 
? K d is the cost of debt 
? D is the market value of debt 
? S is the market value of equity 
? K e is the cost of equity  
Capital structure decision will decide weight of debt and equity and ultimately 
overall cost of capital as well as Value of the firm. So capital structure is relevant in 
maximizing value of the firm and minimizing overall cost of capital. 
Whenever funds are to be raised to finance investments, capital structure decision 
is involved. A demand for raising funds generates a new capital structure since a 
decision has to be made as to the quantity and forms of financing. The process of 
financing or capital structure decision is depicted in the figure below. 
 
 
5.4 FINANCIAL MANAGEMENT  
 
Financing Decision Process 
 5.2 CAPITAL STRUCTURE THEORIES 
The following approaches explain the relationship between cost of capital, capital 
structure and value of the firm:  
 
Capital 
Structure 
Theories
Capital Structure 
Relevance Theory
Net Income (NI) Approach
Traditional Approach
Modigliani and Miller (MM) 
Approach- 1963: with tax
Capital Structure 
Irrelevance Theory
Net Operating Income (NOI) 
Approach
Modigliani and Miller (MM) 
Approach -1958: without tax
Page 5


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS 
 CAPITAL STRUCTURE 
 
 
? State the meaning and significance of capital structure. 
? Discuss the various capital structure theories i.e. Net Income 
Approach, Traditional Approach, Net Operating Income (NOI) 
Approach, Modigliani and Miller (MM) Approach, Trade- off 
Theory and Pecking Order Theory. 
? Describe concepts and factors for designing an optimal 
capital structure. 
? Discuss essential features of capital structure of an entity. 
? Discuss optimal capital structure. 
? Analyse the relationship between the performance of a 
company and its impact on the earnings of the shareholders 
i.e. EBIT-EPS analysis. 
? Discuss the meaning, causes and consequences of over and 
under capitalisation to an entity. 
CHAPTER 
5 
 
 
5.2 FINANCIAL MANAGEMENT  
 
 5.1 MEANING OF CAPITAL STRUCTURE 
Capital structure is the combination of capitals from different sources of finance. 
The capital of a company consists of equity share holders’ fund, preference share 
capital and long term external debts. The source and quantum of capital is decided 
keeping in mind following factors: 
1. Control: capital structure should be designed in such a manner that existing 
shareholders continue to hold majority stake.   
2. Risk: capital structure should be designed in such a manner that financial risk 
of the company does not increases beyond tolerable limit. 
3. Cost: overall cost of capital remains minimum. 
Capital Structure Decision
Capital Structure Theories
? Net Income (NI) Approach 
? Traditional Approach
? Net Operating Income(NOI)
Approach
? Modigliani- Miller (MM)
Approach
? Trade-off Theory
? Pecking Order Theory
Designing an Optimal Capital Structure
EBIT- EPS Analysis
 
 
 
 5.3 
 
FINANCING DECISIONS – CAPITAL STRUCTURE 
Practically, it is difficult to achieve all of the above three goals together, hence, a 
finance manager has to make a balance among these three objectives.  
However, the objective of a company is to maximise the value of the company and 
it is prime objective while deciding the optimal capital structure. Capital Structure 
decision refers to deciding the forms of financing (which sources to be tapped); 
their actual requirements (amount to be funded) and their relative proportions 
(mix) in total capitalisation.  
Value of the firm =
EBIT
Overall cost of capital / Weighted average cost of capital
 
K o = (Cost of debt × weight of debt) + (Cost of equity × weight of equity) 
K o = [{K d × D/ (D+S)} + {K e × S/(D+S)}] 
Where:  
? K o is the weighted average cost of capital (WACC) 
? K d is the cost of debt 
? D is the market value of debt 
? S is the market value of equity 
? K e is the cost of equity  
Capital structure decision will decide weight of debt and equity and ultimately 
overall cost of capital as well as Value of the firm. So capital structure is relevant in 
maximizing value of the firm and minimizing overall cost of capital. 
Whenever funds are to be raised to finance investments, capital structure decision 
is involved. A demand for raising funds generates a new capital structure since a 
decision has to be made as to the quantity and forms of financing. The process of 
financing or capital structure decision is depicted in the figure below. 
 
 
5.4 FINANCIAL MANAGEMENT  
 
Financing Decision Process 
 5.2 CAPITAL STRUCTURE THEORIES 
The following approaches explain the relationship between cost of capital, capital 
structure and value of the firm:  
 
Capital 
Structure 
Theories
Capital Structure 
Relevance Theory
Net Income (NI) Approach
Traditional Approach
Modigliani and Miller (MM) 
Approach- 1963: with tax
Capital Structure 
Irrelevance Theory
Net Operating Income (NOI) 
Approach
Modigliani and Miller (MM) 
Approach -1958: without tax
 5.5 FINANCING DECISIONS – CAPITAL STRUCTURE 
(a) Net Income (NI) approach 
(b) Traditional approach. 
(c) Net Operating Income (NOI) approach 
(d) Modigliani-Miller (MM) approach 
However, the following assumptions are made to understand this relationship. 
? There are only two kinds of funds used by a firm i.e. debt and equity.  
? The total assets of the firm are given. The degree of leverage can be changed 
by selling debt to purchase shares or selling shares to retire debt. 
? Taxes are not considered.  
? The dividend payout ratio is 100%. 
? The firm’s total financing remains constant. 
? Business risk is constant over time. 
? The firm has perpetual life.  
5.2.1  Net Income (NI) Approach 
According to this approach, capital structure decision is relevant to the value of 
the firm. An increase in financial leverage will lead to decline in the weighted 
average cost of capital (WACC), while the value of the firm as well as market price 
of ordinary share will increase. Conversely, a decrease in the leverage will cause an 
increase in the overall cost of capital and a consequent decline in the value as well 
as market price of equity shares. 
 
K e 
Cost of 
Capital %  
K d 
Leverage 
K w