UNIT IV: FINANCING DECISIONS

Introduction
Capital Structure is the proportion of debt, preference and equity capitals in the total
financing of the firm’s assets. The main objective of financial management is to maximize the
value of the equity shares of the firm. Given this objective, the firm has to choose that financing
mix/capital structure that results in maximizing the wealth of the equity shareholders. Such a
capital structure is called as the optimum capital structure. At the optimum capital structure, the
weighted average cost of capital would be the minimum. The capital structure decision
influences the value of the firm through its cost of capital and can affect the share of the earnings
that pertain to the equity shareholders.
The capital structure decision defines the financial risk associated with the firm. The
usage of debt and preference capital in the firm’s capital structure increases the firm’s financial
risk. As debt is the cheaper source of finance, using of more debt increases the profitability of the
firm but the risk associated with the firm also will be increasing. Hence the role of financial
manager is to design the capital structure in such a way to achieve a sense of balance between the
risk and profitability.

MEANING & DEFINITION

It refers to the total combined investment of a business comprising Equity share capital,
Preference share capital, Debentures, Retained earnings and such other long term borrowed
funds.

According to GERSTENBERG the term capital structure refers to “the makeup, form or
composition of a firm’s capitalization, i.e., the types of securities to be issued and relative
proportion of each type of securities in the total capitalization”.

Eg: a company has eq. shares of Rs 1,00,000 , preference shares of Rs1,00,000,

Debentures 1,00,000 & Retained Earnings Rs50,000

Significance of Capital Structure

The need of capital budgeting can be emphasized taking into consideration the very
nature of the capital expenditure such as heavy investment in capital projects, long-term
implications for the firm, irreversible decisions and complicates of the decision making. Its
importance can be illustrated well on the following other grounds:-

1. Indirect Forecast of Sales: The investment in fixed assets is related to future sales of the
firm during the life time of the assets purchased. It shows the possibility of expanding the
production facilities to cover additional sales shown in the sales budget. Any failure to make the
sales forecast accurately would result in over investment or under investment in fixed assets and
any erroneous forecast of asset needs may lead the firm to serious economic results.

2. Comparative Study of Alternative Projects: Capital budgeting makes a comparative study

of the alternative projects for the replacement of assets which are wearing out or are in danger of

1|Page
becoming obsolete so as to make the best possible investment in the replacement of assets. For
this purpose, the profitability of each project is estimated.

3. Timing of Assets-Acquisition: Proper capital budgeting leads to proper timing of assets-

acquisition and improvement in quality of assets purchased. It is due to ht nature of demand and
supply of capital goods. The demand of capital goods does not arise until sales impinge on
productive capacity and such situation occurs only intermittently. On the other hand, supply of
capital goods with their availability is one of the functions of capital budgeting.

4. Cash Forecast: Capital investment requires substantial funds which can only be arranged
by making determined efforts to ensure their availability at the right time. Thus it facilitates cash
forecast.

5. Worth-Maximization of Shareholders: The impact of long-term capital investment

decisions is far reaching. It protects the interests of the shareholders and of the enterprise because
it avoids over-investment and under-investment in fixed assets. By selecting the most profitable
projects, the management facilitates the wealth maximization of equity share-holders.

6. Other Factors: The following other factors can also be considered for its significance:

 It assists in formulating a sound depreciation and assets replacement policy.

 It may be useful n considering methods of coast reduction. A reduction campaign may
necessitate the consideration of purchasing most up-to—date and modern equipment.
 The feasibility of replacing manual work by machinery may be seen from the capital
forecast be comparing the manual cost and the capital cost.
 The capital cost of improving working conditions or safety can be obtained through
capital expenditure forecasting.
 It facilitates the management in making of the long-term plans an assists in the
formulation of general policy.
 It studies the impact of capital investment on the revenue expenditure of the firm such as
depreciation, insure and there fixed assets.

Financial Structure
Finance structure, or financial structure, is the way that a company's assets are financed.
Finance structure is shown on the right side of the company's financial balance sheet. The
financial situation of a company is listed there, beginning with equity capital and then listing the
liabilities from long-term liabilities such as bank loans to short-term liabilities such as money
that is owed by customers.
The finance structure of a company is important because it shows at first sight how
healthy a company is. The equity capital should account for the greatest part of a company’s
financial means. If a company has only a small amount of equity capital, it can get into problems
with interest payments for the loans. When a company needs to pay high interest rates, its
liabilities increase without having its assets increase. The company is then in danger of debt
overload.

2|Page
 Business partners of the company in question are interested in its finance structure as
well. They want to know if the company will be able to pay for goods and services in the future.
For that reason, companies have to make their balance sheets public. Any other company
interested in developing a business relationship with the company can thus look into its finance
structure. The inquiring company can evaluate the other company’s ability to meet future
financial obligations.

Optimum Capital Structure

Optimum capital structure refers to that capital structure at which there is an ideal
relationship between debt and equity securities, resulting in maximising the value of the
company’s equity shares in the stock exchange and minimising the average cost of capital. In
short, optimum capital structure is that capital structure at which the value of the equity shares of
the company in the stock exchange is the maximum, while the average cost of capital is the
minimum.

According to EZRA SOLOMON, Optimum capital structure is “that particular

combination of Debt and Equity which maximizes the value of the firm and minimizes the
Overall cost of capital.

Essential Characteristics of an Optimum Capital structure:

1. Profitability: an ideal capital structure should result in the maximum return to the eq.
shareholders and at the same time maximises the cost of capital. Profitability depends upon the
overall cost of capital. While designing the capital structure, efforts should be made to keep the
overall cost of capital at minimum.

2. Solvency: an ideal capital structure should maintain solvency of the company.

Although borrowed funds are cheaper, excessive debt damages the solvency of the company.
Hence capital structure should not contain more debt.

3. Flexibility: capital structure should not be rigid. The capital structure of a firm should
be sufficiently flexible so that it can be easily increased or decreased at the time of need.

4. Conservatism: feature of conservatism implies the ability of a firm to pay interest and
principal amount to lenders. Capital structure of a firm should not contain more debt, beyond the
debt servicing capacity of a firm.

5. Control: an ideal capital structure should keep controlling position of owners. As

pref. share holders and debt holders carry limited or no voting rights, they hardly disturb the
controlling position of residual owners. Issue of eq.shares disturbs the controlling capacity
directly as the control of the residual owners is likely to get disturbed.

6. Simplicity: a sound capital structure should clearly define the rights of different types
of security holders as this will enable the company to carry on its business affairs smoothly.

3|Page
Determinants of Capital Structure
The capital structure decisions depend on various factors. The important factors which generally
influence the capital structure decision of the firm are
1. Financial leverage: the financial leverage arises out of usage of debt and preference
shares in the capital structure. The leverage can be used to maximize the return of the
equity shareholders. If the return on investment is higher than the rate of interest on the
borrowed funds or the rate of preference dividend, the financial leverage can be used to
maximise the Earnings Per Share (EPS). This is known as ‘Trading on Equity’. The effect
of financial leverage on EPS should be properly analysed before designing the capital
structure.
2. Corporate taxes: the companies enjoy tax benefit on all the interest payments. This
makes the debt cheapest source of financing. If the company is earning high profits, the
usage of debt in the capital structure helps the firm to reduce its tax liability. On the other
hand, the company has to pay dividend tax additional to the corporate tax on the amount
of dividends paid to the equity and preference shareholders. The company should study
the impact of taxation before taking the capital structure decision.
3. Control: the usage of debt or preference capital normally does not cause dilution in the
control. An issue of equity will dilute the ownership of the existing shareholders. If the
management of the company does not want the dilution of their ownership, they prefer
issue of debt or preference shares over equity.
4. Size of the company: Small companies generally rely on the owners’ funds as it is very
difficult the raise long term funds on reasonable terms. Large companies are generally
considered to be less risky by the investors and hence they can raise funds by issue of
different types of financial instruments.
5. Legal Requirements: The legal provisions related to issue of financial securities should
be kept in mind before designing the capital structure. The company has to fulfill various
legal requirements specified by Securities and Exchange Board of India (SEBI) for issue
of share or debt instrument. The relative ease with which these regulations can be met
will have an influence on the capital structure decision.
6. Purpose of financing: The purpose of financing also influences the capital structure
decision of the firm. If the company is raising funds for financing productive activities,
debt finance is suitable as the interest can be paid from profits earned. But if it is for
financing unproductive activities, the company should rely on issue of equity.
7. Floatation costs: The costs involves is raising funds should also be considered while
designing the capital structure. Generally cost involved in raising funds from public by
issue of shares is high compared to cost of raising debt from banks or financial
institutions.
8. Period of finance: The period of requirement of finance also influences the capital
structure decision of the firm. If the firm requires finance for a period of say 8-10 years,
then it can raise funds by issue of debt instruments. If the finance is required perpetually,
then it can raise the funds by issue of equity shares.
9. Provision for Future: The finance manager should create a provision for financing the
future requirements.
10. Stock Market condition: If the stock market is in boom or bullish sentiment is
prevailing in the market, it is easy for the company to raise funds by issue of equity

4|Page
 shares. And if the market is bearish, the company may feel difficult to raise funds by
issue of equity. Hence the condition of the stock markets should also be kept in mind by
the financial manager while designing the capital structure.

Theories on Capital Structure

The capital structure of a firm influences the value of the firm by effecting the firm’s cost
of capital. The capital structure theories or approaches refer to theories or approaches which
explain the inter relationship between capital structure, overall cost of capital and total value of a
firm.
There are 4 basic Capital Structure theories. They are:

1. Net Income Approach

2. Net Operating Income Approach
3. Modigliani-Miller (MM) Approach and
4. Traditional Approach

Assumptions
The capital structure theories are based on various assumptions like:
1. There are only two sources of funds used by a firm: perpetual riskless debt and ordinary
shares.
2. There are no corporate taxes. This assumption is removed later.
3. The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend to
the shareholders and there are no retained earnings.
4. The total assets are given and do not change. The investment decisions are, in other
words, assumed to be constant.
5. The total financing remains constant. The firm can change its degree of leverage (capital
structure) either by selling shares and use the proceeds to retire debentures or by raising
more debt and reduce the equity capital.
6. The operating profits (EBIT) are not expected to grow.
7. All investors are assumed to have the same subjective probability distribution of the
future expected EBIT for a given firm.
8. Business risk is constant over time and is assumed to be independent of its capital
structure and financial risk.
9. Perpetual life of the firm.

NET INCOME (NI) APPROACH

Net Income theory was introduced by David Durand. According to this approach, the
capital structure decision is relevant to the valuation of the firm. This means that a change in the
financial leverage will automatically lead to a corresponding change in the overall cost of capital
as well as the total value of the firm. According to NI approach, if the financial leverage
increases, the weighted average cost of capital decreases and the value of the firm and the market
price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted
average cost of capital increases and the value of the firm and the market price of the equity
shares decreases.

5|Page
 If, therefore, the degree of financial leverage as measured by the ratio of debt to equity is
increased, the weighted average cost of capital will decline, while the value of the firm as well as
the market price of ordinary shares will increase. Conversely, a decrease in the leverage will
cause an increase in the overall cost of capital and a decline both in the value of the firm as well
as the market price of equity shares.
Assumptions of NI approach:

1. There are no taxes

2. The cost of debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investors

The NI approach proposes that with a change in the leverage of the firm, the cost of
capital of the firm changes and also the value of the firm. According to NI approach, if the firm
increases the debt component in the capital structure, the overall cost of capital decreases and the
value of the firm increases and if the firm decreases the debt component in the capital structure,
the value of the firm decreases and the overall cost of capital increases.
According to NI approach, optimum capital structure is one at which Total value of the
firm (V) is the highest & overall Cost of Capital (Ko) is the lowest.
V= S + D
WHERE, V= value of the firm
S= market value of equity
D= market value of debt
Capital K0, decreases and tends to appropriate the cost of debt (Ko=Kd). At this point the
firms overall cost of capital would be minimum. The significant conclusion of NI approach is
that ‘the firm can employ 100percent debt to maximise its value’.

Illustration:
The company’s expected Earnings before Interest and Tax (EBIT) is Rs. 60,000. The company is
presently having 9% debt of Rs. 3,00,000 in this capital structure. The equity capitalisation rate
is 15%.
Solution:
Value of the firm
Amount
EBIT 60,000
Less: Interest (3,00,000× 9%) 27,000
Net Income 33,000
Market value of equity (S) 2,20,000
𝑁𝐼 33,000
S = 𝐾𝑒 = 0.15
Market value of debt (B) 3,00,000
Total value of the firm (V = S + B) 5,20,000
Overall cost of capital 12.11%
𝐵 𝑆
Ko = {𝑉}Kd + {𝑉}Ke
3,00,000 2,20,000
= × 0.09 + × 0.15
5,20,000 5,20,000

Increase debt by Rs. 1,00,000

6|Page
The firm increases debt by Rs. 1,00,000 and use the proceeds to redeem equal amount of equity
capital. At the new level of leverage, the value of the firm can be calculated as under:
Amount
EBIT 60,000
Less: Interest (4,00,000× 9%) 36,000
Net Income 24,000
Market value of equity (S) 1,60,000
𝑁𝐼 24,000
S = 𝐾𝑒 = 0.15
Market value of debt (B) 4,00,000
Total value of the firm (V = S + B) 5,60,000
Overall cost of capital 11.43%
𝐵 𝑆
Ko = {𝑉}Kd + {𝑉}Ke
4,00,000 1,60,000
= × 0.09 + × 0.15
5,60,000 5,60,000
Thus, the use of additional debt in the capital structure resulted in the increase in the value of the
firm from Rs. 5,20,000 to Rs. 5,60,000 and decrease in the overall cost of capital from 12.11% to
11.43%.

Decrease debt by Rs. 1,00,000

The firm decrease debt by Rs. 1,00,000 i.e., from Rs. 3,00,000 to Rs. 2,00,000 and equal amount
of fresh equity is issued to redeem the debt. At the new level of leverage, the value of the firm
can be calculated as under:
Amount
EBIT 60,000
Less: Interest (2,00,000× 9%) 18,000
Net Income 42,000
Market value of equity (S) 2,80,000
𝑁𝐼 24,000
S = 𝐾𝑒 = 0.15
Market value of debt (B) 2,00,000
Total value of the firm (V = S + B) 480,000
Overall cost of capital 12.92%
𝐵 𝑆
Ko = {𝑉}Kd + {𝑉}Ke
2,00,000 2,80,000
= × 0.09 + × 0.15
4,80,000 4,80,000

Thus, the decrease in the debt from Rs. 3,00,000 to Rs. 2,00,000 results in decrease in the value
of the firm from 5,20,000 to Rs. 4,80,000 and increase in the overall cost of capital to 12.92%.
According to NI approach, optimal capital structure is that where the firm enjoys maximum
value and minimum overall cost of capital. According to NI approach, the optimal capital
structure is 100% debt and 0% equity.

NET OPERATING INCOME APPROACH (NOI)

Net Operating Income Approach was also suggested by Durand. This approach is of the
opposite view of Net Income approach. This approach suggests that the capital structure decision

7|Page
of a firm is irrelevant and that any change in the leverage or debt will not result in a change in
the total value of the firm as well as the market price of its shares. This approach also says that
the overall cost of capital is independent of the degree of leverage.

Assumptions
1. The value of the firm is obtained by capitalizing NOI by the Ko which depends on the
business risk. If business risk is constant, ko is also constant.
2. The cost of equity changes with change in degree of leverage.
3. Cost of debt remains same regardless of leverage.
4. There are no corporate taxes
We can graph the relationship between the various factors (ke, kd, ko) with the degree of
leverage
ke

Ko

Kd

kd, ke, ko (%)

DEGREE OF LEVERAGE (B/V)

The Degree of leverage is plotted along the X axis, while the percentage rates (ke,kd,ko) are
plotted on the Y axis . Due to the assumption that Ko and kd remains unchanged as the Degree of
leverage changes, we find that both the curves are parallel to the X axis. But as the degree of
leverage increases, the ke increases continuously.

Example:
Let us assume that a firm has an EBIT level of Rs50,000, cost of debt 10%, the total
value of debt Rs200,000 and the WACC is 12.5%. Let us find out the total value of the firm and
the cost of equity capital (the equity capitalization rate).

Solution:

EBIT = Rs50,000
WACC (overall capitalization rate) = 12.5%
Therefore, total market value of the firm = EBIT/Ko ⇒ Rs50,000/12.5% ⇒ Rs400,000
Total value of debt =Rs200,000
Therefore, total value of equity = Total market value - Value of debt
⇒ Rs400,000 - Rs200,000 ⇒ Rs200,000
Cost of equity capital = Earnings available to equity holders/Total market value of equity shares
Earnings available to equity holders = EBIT - Interest on debt
⇒ Rs50,000 - (10% on Rs200,000) ⇒ Rs30,000
8|Page
Therefore, cost of equity capital =Rs30,000/Rs200,000 ⇒ 15%
Verification of WACC:
10% x (Rs200,000/Rs400,000) + 15% x (Rs200,000/Rs400,000) ⇒ 12.5%

The NOI approach proposes that the value of the firm remain constant for all the levels of
leverage. The usage of additional debt in the capital structure results in increase in the financial
risk of the firm and hence the equity shareholders expect higher rate of return. The benefit
derived from the use of debt in the capital structure is exactly neutralized with the increase in the
cost of equity. Thus, the overall cost of capital will remain constant.

MODIGLIANI MILLAR APPROACH (M-M Hypothesis)

Modigliani Millar approach, popularly known as the MM approach is similar to the Net
operating income approach. The MM approach favors the Net operating income approach and
agrees with the fact that the cost of capital is independent of the degree of leverage and at any
mix of debt-equity proportions. The significance of this MM approach is that it provides
operational or behavioral justification for constant cost of capital at any degree of leverage.
Whereas, the net operating income approach does not provide operational justification for
independence of the company's cost of capital.

Assumptions of MM approach:
The proposition that the weighted average cost of capital is constant irrespective of the
type of capital structure is based on the following assumptions:
a) Existence of perfect capital markets: The implication of a perfect capital market is that
(i) securities are infinitely divisible;
(ii) investors are free to buy/sell securities;
(iii) investors can borrow without restrictions on the same terms and conditions as
firms can;
(iv) there are no transaction costs;
(v) information is perfect, that is, each investor has the same information which is
readily available to him without cost; and
(vi) investors are rational and behave accordingly.
b) Given the assumption of perfect information and rationality, all investors have the same
expectation of firm's net operating income (EBIT) with which to evaluate the value of a
firm.
c) Business risk is equal among all firms within similar operating environment. That means,
all firms can be divided into 'equivalent risk class' or 'homogeneous risk class'. The term
equivalent/homogeneous risk class means that the expected earnings have identical risk
characteristics. Firms within an industry are assumed to have the same risk
characteristics. The categorisation of firms into equivalent risk class is on the basis of the
industry group to which the firm belongs.
d) The dividend payout ratio is 100 per cent.
e) There are no taxes. This assumption is removed later.

According to this approach, the value of the firm remains constant at various levels of leverages.
The basis for the MM approach is the process of arbitration. Arbitration is the process of taking
two equal and opposite positions in two different markets. The MM hypothesis illustrates the
arbitration process between two firms which are similar in all the aspects i.e., the firms which
9|Page
belong to the same equivalent risk class, expect in the capital structure. The arbitration process
corrects any imbalance in the values of the firms belonging to the same equivalent risk classes in
such a way that no further arbitration is possible.

Arbitrage process
Arbitrage process is the operational justification for the Modigliani-Miller hypothesis.
Arbitrage is the process of purchasing a security in a market where the price is low and selling it
in a market where the price is higher. This results in restoration of equilibrium in the market
price of a security asset. This process is a balancing operation which implies that a security
cannot sell at different prices. The MM hypothesis states that the total value of homogeneous
firms that differ only in leverage will not be different due to the arbitrage operation. Generally,
investors will buy the shares of the firm that's price is lower and sell the shares of the firm that's
price is higher. This process or this behavior of the investors will have the effect of increasing
the price of the shares that is being purchased and decreasing the price of the shares that is being
sold. This process will continue till the market prices of these two firms become equal or
identical. Thus the arbitrage process drives the value of two homogeneous companies to equality
that differs only in leverage.

Limitations of MM hypothesis:
a) Investors would find the personal leverage inconvenient.
b) The risk perception of corporate and personal leverage may be different.
c) Arbitrage process cannot be smooth due the institutional restrictions.
d) Arbitrage process would also be affected by the transaction costs.
e) The corporate leverage and personal leverage are not perfect substitutes.
f) Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.

The most crucial element in the MM Approach is the arbitrage process which forms the
behavioral foundation of, and provides operational justification to, the MM hypothesis. The
arbitrage process, in turn, is based on the crucial assumption of perfect substitutability of
personal/home-made leverage with corporate leverage. The validity of the MM hypothesis
depends on whether the arbitrage process is effective in the sense that personal leverage is a
perfect substitute for corporate leverage. The arbitrage process is, however, not realistic and the
exercise based upon it is purely theoretical and has no practical relevance.

MM hypothesis under corporate taxes:

In the year 1963, Modigliani and Miller have indentified that with the introduction of corporate
taxes in the computation process, the value of the firm increases and overall cost of capital
decrease with the use of leverage in the capital structure. This is mainly because of the tax
benefit enjoyed by the firm’s on the interest payments.

TRADITIONAL APPROACH
The NOI approach and NI approach represents the two extremes of the theoretical
relationship between the capital structure and the value of the firm. The traditional approach is an
intermediate approach between these two extremes. It resembles NI approach, as this theory
argues that the capital structure decision is relevant to the value of the firm. But it does not
support the concept that value of firm continuously increase with the increase in leverage. It

10 | P a g e
resembles NOI approach, as this theory also argues that the cost of equity changes with the
changes in the leverage. It also argues that the cost of debt also increases with increase in
leverage.
According to this theory a proper and right combination of debt and equity will always
lead to market value enhancement of the firm. This approach accepts that the equity shareholders
perceive financial risk and expect premiums for the risks undertaken. This theory also states that
after a level of debt in the capital structure, the cost of equity capital increases.
The manner in which the overall cost of capital and value of the firm react to changes in
capital structure can be discussed in three stages. Those stages are:
Stage I: (Increasing value):
The first stage begins with the introduction of debt in the firm’s capital structure. The
cost of equity (Ke) remains constant or rises slightly with the addition of debt. But when it
increases, it does not increase fast enough to offset the advantage of low cost debt. The cost of
debt (kd) remains constant or rises negligibly.

As the cost of debt is less than cost of equity, increased use of debt reduces the overall
cost of capital during the 1st stage.

Stage II: (Optimum Value)

Once the firm has reached certain Degree of leverage, increased use of debt does not
result in the fall in the overall cost of capital. This is due to the fact that benefits of low cost debt
are offset by the increase in the cost of equity. Within this range cost of capital will be the
minimum or the value of the firm will be the maximum.

Stage III: (Decreasing Value)

Beyond a particular point the use of debt has unfavorable effect on the cost of capital and
the value of the firm. The cost of debt & equity as a result of the increasing risks attached to each
of them and this leads to an increase in the overall cost of capital. As a consequence of this, the
market value of the firm tends to decline.

11 | P a g e