CAPITAL STRUCTURE THEORIES | CAP CLASSES

https://www.youtube.com/watch?v=j26L7QeezP8

PART 1: WHAT IS CAPITAL STRUCTURE?

Capital Structure refers to the mix of sources from where the long-term funds required in a business may be raised.

In other words it refers to the proportion of debt, preference capital and equity capital.

For Example, if a company raises its required capital of Rs. 100 crores as

Sl No	Source of Capital	Amount (Rs in Crores)	Proportions (in %)
1	Equity Share Capital	40	40%
2	Preference Share Capital	10	10%
3	Reserves & surplus	10	10%
4	Debentures	25	25%
5	Long term loans	15	15%
6	Total Capital Employed	100	100%

In the above example the capital structure of the company is 40% equity share capital, 10% preference share capital, 10% reserves and surplus, 25% debentures and 15% long term loans.

PART 2: OPTIMUM CAPITAL STRUCTURE

Putting it simple, optimum capital structure is a capital structure where the cost of the capital of the firm is the lowest and the value of the firm is highest. (The whole concept of capital structure theories explains the relationship between these three important elements.

1)    Cost of capital

2)    Capital structure

3)    Value of the firm

PART 3: THE IMPORTANCE OF CAPITAL STRUCTURE

a)      One of the basic objectives of financial management is to maximise the value or wealth of the firm.

b)      Capital Structure is optimum when the firm has a combination of equity and debt so that the wealth of the firm is maximum.

c)      At this level, cost of capital is minimum and market price per share is maximum.

d)      In theory, one can speak of an optimum capital structure; but in practice, appropriate capital structure is a more realistic term than the former.

PART 4: CONSIDERATIONS IN PLANNING CAPITAL STRUCTURE

Three major considerations in Capital Structure Planning are:

1)    Risk            

2)    Cost and

3)    Control

Various sources of capital have different characteristics. It is explained below.

Source	Risk	Cost	Control
Equity Capital	Low Risk (for the company) High Risk (for the investor) This is because of two reasons. a)   There is no repayment of capital except under liquidation. b)   A fixed sum of money need not be paid as in the case of loans	Equity is the costliest source of finance for a company. This is because of two reasons. a)  Since the investors are taking more risk, naturally they expect more return. So, it’s costly for the company. b)  Dividends are not tax deductible. So, there is no tax benefit on it like in case of loans.	Issue of equity shares results in dilution of control Since the capital base might be expanded and new shareholders are involved (public).
Preference Capital	Slightly higher risk when compared to Equity Capital (for the company) Low risk for shareholders compared to equity. Principal is redeemable after a certain period. A fixed rate of dividend is to be given. However, dividend payment is based on profits.	Slightly cheaper cost than Equity but higher than Interest rate on loan funds. Further, preference dividends are not tax- deductible.	No dilutions of control since voting rights are restricted.
Loan Funds	High risk for the company. Low risk for shareholders.   a)  Capital should be repaid as per agreement; b)  Interest should be paid irrespective of performance or profits	Low Cost to the company for two reasons. a)  Usually interest rates are lower than dividend rates. b)  Interest is tax deductible. So, the company gets tax benefits.	No dilution of control, since loans will not result in ownership. However, some financial institutions may insist on nomination of their representatives in the Board of Directors. (Nominee Directors)

PART 5: CAPITAL STRUCTURE THEORIES

Capital Structure Theories seek to explain the relationship between the following:

a)    Cost of Capital of the firm

b)    Capital structure and

c)    Value of the Firm

These theories can be broadly classified into two categories:

1)    Theories which suggest that capital structure (i. e debt equity mix) affects WACC

2)    Theories which suggest that capital structure (i. e debt equity mix) does not affect WACC which is a constant.

Example:

If the cost of capital (Ko) of X Ltd is 16% and the present capital structure (debt equity mix) of the company is 50:50, and suppose if the proposed (new) capital structure is 25:75; will the cost of capital remain at 16% or will it change?

In simple terms, will capital structure effect cost of capital?

Interestingly, the answer for the above question can be an YES and it can be a NO.

Capital Structure Theories are broadly classified into two.  They are

a)   Capital structure relevance theories (they explain that the cost of capital is affected by the capital structure of the company). That means the answer for the above question is YES. That means the new cost of capital will not be 16%

Net Income Approach and Traditional Approach are capital structure relevance theories.

b)  Capital structure irrelevance theories (according to these theories, the cost of capital of the company is constant and is not affected by the changes in capital structure. That means the cost of capital remains at 16%.

Net Operating Income Approach and Modigliani & Miller approach are capital structure irrelevance theories.