ICAI Notes: Financing Decisions- Capital Structure | Financial Management & Strategic Management for CA Intermediate PDF Download

 Page 1


 
LEARNING OUTCOMES 
a
    
 
 
CHAPTER 
5 
 
 
 
 FINANCING 
 DECISIONS- 
 CAPITAL STRUCTURE 
 
 
 
After studying this chapter, you would be able to - 
? State the meaning and significance of Capital Structure. 
? Discuss the various capital structure theories i.e., Net Income (NI) 
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-MPS 
analysis. 
? Discuss the meaning, causes and consequences of over and under 
capitalisation to an entity. 
 
© The Institute of Chartered Accountants of India
Page 2


 
LEARNING OUTCOMES 
a
    
 
 
CHAPTER 
5 
 
 
 
 FINANCING 
 DECISIONS- 
 CAPITAL STRUCTURE 
 
 
 
After studying this chapter, you would be able to - 
? State the meaning and significance of Capital Structure. 
? Discuss the various capital structure theories i.e., Net Income (NI) 
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-MPS 
analysis. 
? Discuss the meaning, causes and consequences of over and under 
capitalisation to an entity. 
 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.2 
FINANCIAL MANAGEMENT  
 
 
  
 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 the following factors: 
i. Control: Capital structure should be designed in such a manner that 
existing shareholders continue to hold majority stake.   
ii. Risk: Capital structure should be designed in such a manner that financial 
risk of a company does not increase beyond tolerable limit. 
iii. 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-MPS Analysis
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
Page 3


 
LEARNING OUTCOMES 
a
    
 
 
CHAPTER 
5 
 
 
 
 FINANCING 
 DECISIONS- 
 CAPITAL STRUCTURE 
 
 
 
After studying this chapter, you would be able to - 
? State the meaning and significance of Capital Structure. 
? Discuss the various capital structure theories i.e., Net Income (NI) 
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-MPS 
analysis. 
? Discuss the meaning, causes and consequences of over and under 
capitalisation to an entity. 
 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.2 
FINANCIAL MANAGEMENT  
 
 
  
 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 the following factors: 
i. Control: Capital structure should be designed in such a manner that 
existing shareholders continue to hold majority stake.   
ii. Risk: Capital structure should be designed in such a manner that financial 
risk of a company does not increase beyond tolerable limit. 
iii. 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-MPS Analysis
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
 
 
 5.3 FINANCING DECISIONS – CAPITAL STRUCTURE 
   
 
5.3 
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. 
© The Institute of Chartered Accountants of India
Page 4


 
LEARNING OUTCOMES 
a
    
 
 
CHAPTER 
5 
 
 
 
 FINANCING 
 DECISIONS- 
 CAPITAL STRUCTURE 
 
 
 
After studying this chapter, you would be able to - 
? State the meaning and significance of Capital Structure. 
? Discuss the various capital structure theories i.e., Net Income (NI) 
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-MPS 
analysis. 
? Discuss the meaning, causes and consequences of over and under 
capitalisation to an entity. 
 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.2 
FINANCIAL MANAGEMENT  
 
 
  
 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 the following factors: 
i. Control: Capital structure should be designed in such a manner that 
existing shareholders continue to hold majority stake.   
ii. Risk: Capital structure should be designed in such a manner that financial 
risk of a company does not increase beyond tolerable limit. 
iii. 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-MPS Analysis
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
 
 
 5.3 FINANCING DECISIONS – CAPITAL STRUCTURE 
   
 
5.3 
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. 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.4 
FINANCIAL MANAGEMENT  
 
Financing Decision Process 
© The Institute of Chartered Accountants of India
Page 5


 
LEARNING OUTCOMES 
a
    
 
 
CHAPTER 
5 
 
 
 
 FINANCING 
 DECISIONS- 
 CAPITAL STRUCTURE 
 
 
 
After studying this chapter, you would be able to - 
? State the meaning and significance of Capital Structure. 
? Discuss the various capital structure theories i.e., Net Income (NI) 
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-MPS 
analysis. 
? Discuss the meaning, causes and consequences of over and under 
capitalisation to an entity. 
 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.2 
FINANCIAL MANAGEMENT  
 
 
  
 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 the following factors: 
i. Control: Capital structure should be designed in such a manner that 
existing shareholders continue to hold majority stake.   
ii. Risk: Capital structure should be designed in such a manner that financial 
risk of a company does not increase beyond tolerable limit. 
iii. 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-MPS Analysis
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
 
 
 5.3 FINANCING DECISIONS – CAPITAL STRUCTURE 
   
 
5.3 
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. 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.4 
FINANCIAL MANAGEMENT  
 
Financing Decision Process 
© The Institute of Chartered Accountants of India
 
 
 5.5 FINANCING DECISIONS – CAPITAL STRUCTURE 
   
 
5.5 
 2. CAPITAL STRUCTURE THEORIES 
The following approaches explain the relationship between cost of capital, capital 
structure and value of the firm:  
 
(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.  
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
© The Institute of Chartered Accountants of India