Financial Management- Capital Structure Notes
Capital Structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long-term debt, preference share capital and shareholders’ funds.
The importance of designing a proper capital structure is explained below
(i) Value Maximization
Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital structure the aggregate value of the claims and ownership interests of the shareholders are maximized.
(ii) Cost Minimization
Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.
(iii) Increase in Share Price
Capital structure maximizes the company’s market price of share by increasing earnings per share of the ordinary shareholders. It also increases dividend receipt of the shareholders.
(iv) Investment Opportunity
Capital structure increases the ability of the company to find new wealth- creating investment opportunities. With proper capital gearing it also increases the confidence of suppliers of debt.
(v) Growth of the Country
Capital structure increases the country’s rate of investment and growth by increasing the firm’s opportunity to engage in future wealth-creating investments.
Theories of Capital Structure
1. NI Approach
According to NI approach a firm may increase the total value of the firm by lowering its cost of capital.
When cost of capital is lowest and the value of the firm is greatest, we call it the optimum capital structure for the firm and, at this point, the market price per share is maximized.
The same is possible continuously by lowering its cost of capital by the use of debt capital. In other words, using more debt capital with a corresponding reduction in cost of capital, the value of the firm will increase.\
The same is possible only when:
(i) Cost of Debt (Kd) is less than Cost of Equity (Ke)
(ii) There are no taxes; and
(iii) The use of debt does not change the risk perception of the investors since the degree of leverage is increased to that extent.
Since the amount of debt in the capital structure increases, weighted average cost of capital decreases which leads to increase the total value of the firm. So, the increased amount of debt with constant amount of cost of equity and cost of debt will highlight the earnings of the shareholders.
Scenario A: 6% * (0 / 100000) + 10% *(100000 / 100000) = 10 %
Scenario B: 6% * (50000/120000) + 10% * (70000 / 100000) = 8.33%
Net Operating Income Approach
Taking an opposite view from the view taken in the net income approach, 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.
Putting it simply, according to the net operating income approach; for all degrees of leverage,
· Overall capitalization rate remains constant
· The cost of debt remains same
Given this, and manipulating the equation of the firm's total cost of capital, we can
express the cost of equity as:
Assumptions of the Net Operating Income Approach (NOI)
(1) The firm is evaluated as a whole by the market. Accordingly, overall capitalization rate is used to calculate the value of the firm. The split of capitalization between debt and equity is not significant.
(2) Overall capitalization rate remains constant regardless of any change in degree of financial leverage.
(3) Use of debt as cheaper source of funds would increase the financial risk to shareholders who demand higher cost on their funds to compensate for the additional risk. Thus, the benefits of lower cost of debt are offset by the higher cost of equity.
(4) The cost of debt would stay constant.
(5) The firm does not pay income taxes.
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