Capital structure in corporate finance is the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders’ equity, debt (borrowed funds), and preferred stock, and is detailed in the company’s balance sheet. The larger the debt component is in relation to the other sources of capital, the greater financial leverage (or gearing, in the United Kingdom) the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital. Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible.
Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States. The utility company has the right to choose any capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes.
Various leverage or gearing ratios are closely watched by financial analysts to assess the amount of debt in a company’s capital structure.
- In order to find out an optimum equity debt mix, the finance manager should know the theories underlying the capital structure of the firm.
- It is seen that existence of optimal capital structure is not accepted by all.
- One group of the people thinks that the debt equity mix has major impact on the shareholders wealth, whereas other group thinks, it does not have any impact.
Optimal capital structure
Optimal capital structure is required to maintain financial stability. The optimal capital structure is that where the market value of shares is maximum.
It can be a ratio between debt and equity where the share price of its shares at a stock exchange increases. And the cost of capital is minimum.
ROI, leverage on account of corporate taxes and perceived risk factor.
Assumption of Capital Structure:
(i) Only two sources of funds i.e. debt and equity, no preference share capital.
(ii) No taxes, this has been taken back later.
(iii) Dividend payout is 100%, no retained earnings.
(iv) Investment decisions are constant, no changes in assets.
(v) Total financing remains same, firm changes the capital structure either by redeeming the debenture by issue of shares of raising more funds.
(vi) EBIT are not expected to grow.
(vii) Business risk remains constant and independent of capital structure.
(viii) firm has perpetual life.
Net Income (NI) approach
- Provided by Durand, it says that capital structure is relevant to valuation of firm.
- According to this approach higher debt content in the capital structure will result in decrease of overall or WAC of the capital.
- This will increase in the value of the firm and consequently increase in the value of equity shares of the firm and vice versa.
Assumptions of NI approach
(i) There are no corporate taxes.
(ii) The cost of debt is less than the cost of equity.
(iii) The debt content does not change the risk perception of the investors.
The value of the firm is ascertained as under:
V = S+B, V means value of firm, S market value of equity and B market value of debt respectively. Here, S = NI/Ke, NI means PAT and ke is the cost of equity capital or capitalisation rate.
Net Operating Income (NOI) approach
- Also Provided by Durand, it says that capital structure is not relevant to valuation of firm.
- Any change in leverage will not lead to any change in the total value of the firm.
- This approach states that the cost of capital for the whole firm remains constant, irrespective of the leverage employed in the firm.
- With the cost of debt and the cost of capital constant, we can say that the cost of equity capital changes with the leverage to compensate for the additional level of risk.
Modigiliani and Miller Approach
- Similar to NOI approach, according to this the value of the firm is independent of its capital structure.
- The basic difference between NOI and MM approach is that NOI is purely definitional whereas MM approach provide behavioural justification for the independence of valuation and cost of capital of the firm from its capital structure.
Assumptions of MM approach:
- Capital markets are perfect: investors are free to buy and sell, well informed, no restriction on borrow, behave rationally and no transaction cost.
- Homogenous firms shall have same degree of business risk.
- Dividend payout ratio is 100%. No taxes.
- All investors have the same expectation of EBIT.
Arbitrage process is the operational justification of MM hypothesis. It refers to an act of buying an asset or security in one market having lower price and selling it in another market at a higher price.
The consequence of such action is that market price of securities of two firms can not remain different for longer period in different markets except to their different capital structures. Thus arbitrage process restores equilibrium in value of securities.
- NI approach held that debt content in the capital structure affects both the WACC and value of the firm. NOI & MM approach held that capital structure is totally irrelevant as far as WACC and value of the firm is concerned. The assumptions of MM approach are of doubtful validity.
- Therefore, traditional/intermediate approach is mid way of two approaches. It partly contains features of both the approaches.
- It agrees with NI to the extent that capital structure affects the overall cost of capital and value of the firm but does not agree that the value of the firm will increase and with all degree of leverages.
- It subscribes to the NOI that beyond a certain degree of leverage the WACC increases resulting in decrease of total value of the firm. But differs from NOI that WACC will not remain constant for all degree of leverages.
Factors determining Capital Structure
- Financial Leverage
- Growth and Stability of Sales
- Cost of Capital
- Cash Flow Ability to Service the Debt
- Nature and Sign of Firm
- Requirement of Investors
- Capital Market Conditions
- Assets Structure
- Period of Financing
- Purpose of Financing
- Costs of Floatation
- Personal Consideration
- Corporate Tax rate
- Timing of Issue
CS structure practices in India:
Capital structure and cost of capital: Traditional view, the cost of capital is affected by the debt and equity mix still holds good.
Choice between debt and equity: earlier debt was preferred to have tax benefits, but prefer equity due to freedom in dividend and easy to raise money.
Share Valuation: Relationship between share price and variables like return, risk, growth and leverages that affects the value of the firm.