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Importance Of Capital Structure To A Firm Finance Essay

Paper Type: Free Essay Subject: Finance
Wordcount: 5333 words Published: 1st Jan 2015

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"Capital Structure of a company refers to the composition or make-up of its capitalization and it includes all long-term capital resources, viz. Loans, reserves, shares and bonds,"-Gestenberg


Capital Structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision variables. Poor capital structure decisions can result in high cost of capital thereby lowering the Net Present Values of projects and making more of them unacceptable. Effective capital structure decision can lower the cost of capital , thereby increasing the value of the firm.

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It is particularly important for small business owners to determine a target capital structure for their firms, since capital is expensive for such small businesses. Capital structure decisions require considering a variety of factors. In general, companies use debt more when they have steady, constant sales levels, assets that have good returns for loans and a high growth rate . On the other hand, companies that have poor credit ratings, conservative management, or high profitability rely on equity capital instead.

Capital Structure

Capital structure is a business finance term that describes 'the proportion of a company's capital, or operating money, which is obtained through debt and equity or hybrid securities' [1]. Debt consists of loans and other types of credit that is to be repaid in the future, usually with interest. Equity involves ownership interest in a corporation in the form of common stock or preferred stock. Equity financing does not involve a direct obligation to repay the funds which is in contrast to debt financing,. Instead, equity investors are able to exercise some degree of control over the company as they become part-owners and partners in the business.

The goal of a company's capital structure decision is to maximize the gains for the equity shareholders. The optimal capital structure is the one that maximizes the price of the stock and simultaneously minimizes the cost of capital thus striking a balance between risk and return. [2]

A firm's major decision is its financial decisions which can be analyzed in the theory of Corporate Capital Structure that is based on a model developed by Dodd(1986) and is determined mainly by cost variables- equity, debt and bankruptcy risk and other potential variables such as growth are, profitability and operating leverage.

The primary advantage of debt financing is that it allows the founders to retain ownership and control of the company. Equity investors' claim does not end until their stock is sold as compared to debt obligations which are limited to the loan repayment period, after which the lender has no further claim on the business. Debt financing tends to be less expensive for small businesses over the long term, though more expensive over the short term, than equity financing. The major disadvantage is that it requires a small business to make regular monthly payments of principal and interest. Due to such regular payments, young companies often experience shortages in cash flow. Debt financings availability is often limited to established businesses which is a disadvantage associated with it. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans.

The main advantage of equity financing for small businesses is that there is no obligation to repay the money. The investors in equity financing often prove to be good sources of advice and contacts for small business owners. The main disadvantage of equity financing is that the founders must give up some control of the business. Some sales of equity, such as initial public offerings, can be very complex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations.

Features of a Capital Structure

Capital structure is that level of debt-equity proportion where the market value per-share is maximum and the cost of capital is minimum.

It should have the following features:

Profitability/Return: Studies have shown that the relationship between debt-equity ratio and a firm's profit margin is such that for a firm which prefers to finance its investments through self-finance are more profitable than firms which finance investment through borrowed capital, firms prefer competing with each other than cooperating and firms use their investment in fixed assets as a strategic variable to affect profitability.[3]

Solvency/Risk: Capital Structure of a firm indicates how much the company is leveraged by comparing what it owes to creditors and investors to what it owns. It reveals the degree to which the company's management is willing to fund its operations with debt, rather than equity. Lenders are sensitive about this feature as a high debt-equity ratio will put their loans at risk of being unpaid.[4]

Flexibility: Flexibility is the ability to make decisions that the firm thinks are most apt even when others disagree. The level of flexibility the management can have depends on how the firm is financed. Debt offers little flexibility relative to equity. However, the flexibility offered by equity depends on the extent to which shareholders are inclined to agree with management's strategic choices. The flexibility benefit of equity is high only when the share price is high.[5]

Conservation/Capacity: If a firm starts with a specific business risk, then the total risk associated with stock and debt is not affected by the capital structure. This is called 'conservation of risk'. Risk is neither created nor destroyed.[6] Debt capacity involves the assessment of the amount of debt that the organization can repay in a timely manner without forfeiting its financial viability.[7]

Control: The capital structure of a firm shows when control is allocated to only shareholders and when to others like creditors, or the management team. Generally the shareholders get control when the firm's cash flow is sensitive. Also , debt value and firm value are negatively correlated when debtholders have veto power[8] 

Determinants of Capital Structure

Capital structure of a firm is determined by various internal and external factors. The macro variables of the economy are inflation rate, tax policy of government, capital market condition. The characteristics of an individual firm, termed as micro factors (internal), also affect the capital structure of enterprises. This section presents how the micro-factors affect the capital structure of a firm

Size of a Firm: There is a positive relation between the capital structure and size of a firm. The larger the firms the more diversified they are. They have easy access to the capital market, receive higher credit ratings for debt issues, and pay lower interest rate on debt capital. Further, larger firms are less prone to bankruptcy and this implies the less probability of bankruptcy and lower bankruptcy costs. Hence, the lower bankruptcy costs, the higher debt level.[9]

Growth Rate: There is a contradictory relation between the growth rate and capital structure. The equity controlled firms tend to invest sub-optimally to get wealth from the enterprises' bondholders. They are more flexibility in their choice of future investment. Hence, growth rate is negatively related with long-term debt level.[10]

Business Risk: There is a negative relation between the capital structure and business risk. Lesser the stability of the earnings of the enterprises, the greater is the chance of business failure and the greater the weight of bankruptcy costs on enterprise financing decisions. Hence, as business risk increases, the debt level in capital structure of the enterprises should decrease.[11]

Dividend Payout: There is an adverse relation between the dividend payout ratio and debt level in capital structure. The low dividend payout ratio means increase in the equity base for debt capital and low probability of going into liquidation. As a result of low probability of bankruptcy, the bankruptcy cost is low. This implies high level of debt in the capital structure.[12]

Operating Leverage: The use of fixed cost in production process also affects the capital structure. The high operating leverage-use of higher proportion of fixed cost in the total costs over a period of time-can magnify the variability in future earnings. There is a negative relation between operating leverage and debt level in capital structure. The higher operating leverage, the greater the chance of business failure and the greater will be the weight of bankruptcy costs on enterprise financing decisions.

Industry Life Cycle: Firms tend to adopt different financing strategies and a specific hierarchy of decision-making as they progress through the phases of their business life cycle. Debt is fundamental to business activities in the early stages, representing the first choice. However, in the maturity stage, firms re-balance their capital structure, substituting debt for internal capital.[13]

Degree of Competition: Debt ratios are reduced as the scope of competition falls. For oligopolies, debt ratios show a significant and positive effect on prices.[14]

Company Characteristics: Variables of size and growth opportunity in total assets reveal a positive association with the leverage ratio, however, profitability, growth opportunities in plant, property and equipment, non-debt tax shields and tangibility reveal inverse relation with debt level.[15]

Forms of Capital Structure

Capital Structure can be of various forms:

Horizontal capital Structure: The firm has no component of debt in the financial mix. Expansion of the firm is through equity and retained earnings only.

Vertical Capital Structures: The base of the structure is a little amount of equity share capital which serves as the foundation for a super structure of preference share capital and debt.

Pyramid Shaped Capital Structure: Large proportion consisting of equity capital and retained earnings.

Inverted Pyramid shaped Capital Structure: Small component of equity capital, reasonable retained earnings and increasing component of debt.





Capital Structure Decision

Desired Debt-Equity Mix

Existing Capital Structure

Payout Policy

Effect on Return

Effect on Risk

Effect on Cost of Capital

Value of Firm

Optimum Capital Structure

Capital Budgeting Decision

Need for Funds

Capital Structure Decision Process

Internal Funds


External Equity


Weighted Average Cost of Capital

It is the expected rate of return on the market value of all the firm's securities. Anything that increases the value of the firm also minimizes the WACC if operating income is constant.

It is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing: 

WACC = E/V * Re + D/V * Rd * (1- Tc)


Re = cost of equity 

Rd = cost of debt 

E = market value of the firm's equity 

D = market value of the firm's debt 

V = E + D 

E/V = percentage of financing that is equity 

D/V = percentage of financing that is debt 

Tc = corporate tax rate 


There is no income tax, corporate or personal.

The firm believes in paying all of its earnings and dividends. A 100% dividend payout ratio is assumed.

Investors have identical probability distributions of operating income for each company.

The operating income is not expected to grow or decline over time.

A firm can change its capital structure instantaneously without incurring transaction costs.

rd represents the cost of debt

For 100% dividend payout, re represents cost of equity

V = D + E. ra is the overall capitalisation rate of the firm. It can also be expressed as:

ra = rd[D/(D+E)] + re[E/(D+E)]


According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. This means that, the average cost of capital declines and the firm value increases with debt. This happens because when D/E increases, rd which is lower than re, receives a higher weight in the calculation of ra.

This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.

This can be illustrated with the help of a numerical. There are 2 firms A and B similar in all aspects except in the degree of leverage employed.

Firm A

Firm B

Operating income(Rs.)



Interest on debt(Rs.)



Equity Earnings(Rs.)



Cost of equity capital



Cost of debt capital



Market Value of equity(Rs.)



Market value of debt(Rs.)



Total value of the firm(Rs.)



The average cost of capital for firm A is 10%.

The average cost of capital for firm B is 8.66%


It is the opposite of NI Approach. According to NOI approach the value of the firm and the overall capitalization rate are independent of the firm's capital structure.

That is, ra and rd are constant for all degrees of leverage.

Now, re = ra + (ra - rd)(D/E)

The market capitalizes the firm as a whole at a discount rate which is independent of the firm's debt-equity ratio. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same.

An increase in the use of debt funds which are cheaper is offset by an increase in the equity capitalization rate. This happens because equity investors seek higher compensation as they are exposed to greater risk from increase in the degree of leverage. They increase the capitalization rate re as the leverage increases.

Numerically, this can be explained. Two firms A and B are similar in all aspects except the degree of leverage employed by them.

Firm A

Firm B

Operating income(Rs.)



Overall capitalization rate



Total market value



Interest on debt(Rs.)



Debt capitalization rate



Market Value of debt(Rs.)



Market value of equity(Rs.)



Degree of leverage



Equity Capitalization for Firm A= (9,000/56,667) = 15.9%

Equity Capitalization for Firm B = (7,000/36,667) = 19.1%


The traditional approach argues that 'moderate degree of debt can lower the firm's overall cost of capital and thereby, increase the firm value'. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.

The principal implication of the traditional approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimizes the cost of capital. At this level, the real marginal cost of debt and equity is the same.


Similar to NOI Approach

Value of the firm is independent to its capital structure i.e. Independence of total valuation and the cost of capital of the firm from its capital structure

NOI is purely conceptual, Doesn't provide operational justification

Supports NOI and provides behavioral justifications.


Capital market is perfect

(i)Investors are free to buy and sell

(ii) Well informed market

(iii) Firm & investors can borrow on the same terms

(iv) Rational behavior of investors

(v) No transaction cost

Homogeneous risk class

All investors have the same expectations of the firm's EBIT

No Corporate Tax

Preposition I

'The value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure.'[16]

V= D + E = O/r

Where: O is the expected operating income; r is the discount rate applicable to risk class.

MM invokes an arbitrage argument to prove the preposition. In equilibrium, identical assets sell for the same price, irrespective of how they are financed. This is also known as the law of conservation of value.

Arbitrage Argument

Consider two firms U and L, similar in all respects except in their capital structure. Firm U is unlevered, financed by equity alone and firm L is a levered firm.

Firm A

Firm B

Operating income(Rs.)






Equity Earnings



Cost of equity



Market value of equity



Cost of debt



Market value of debt



Market value of the firm



Average cost of capital



The value of the levered firm is higher than that of the unlevered firm. Such, a situation, argue MM, cannot persist because equity investors would do well to sell their equity in firm L and invest in firm U with personal leverage. For example, if an investor owns 10% equity in firm L, he would:

Sell his equity in firm L for Rs. 56,250

Borrow Rs. 50,000, an amount equal to 10% of L's debt at an interest rate of 12%.

Buy 10% of firm U's equity for 1,00,000.

His income remains the same.

Old income from investment in firm L

New income from investment in firm U

10% firms equity income



12% interest on loan of Rs. 50,000




When investors sell their equity in firm L and buy the equity in firm U, the marker value of firm L tends to decline and the market value of firm U tends to rise. This process continues until the market value of both the firms become equal. As a result, the cost of capital for both the firms becomes the same.

Preposition II

Firm A

100% equity

Firm B


Expected earnings per share (Rs.)



Price per share(Rs.)



Expected return to equity shareholders



An increase in financial leverage increases the expected earnings per share but not the share price. This is because the change in the expected earnings is offset by a corresponding change in the return required by shareholders.

We know, re = ra + (ra-rd)(D/E)

Preposition II states that 'The expected return on equity is equal to the expected rate of return on assets, plus a premium. The premium is equal to the debt-equity ratio times the difference between the expected return on assets and the expected return on debt.'

The general implications are that for low levels of debt, the firm's debt is considered risk-free. This means that rd is independent of D/E and hence re increases linearly with D/E. As the debt reaches a threshold limit, the risk of default increases and the return on debt rd rises. To compensate this , the rate of increase in re decreases. This happens because, beyond the threshold level, a portion of the firm's business risk is borne by the suppliers of the debt capital.

WACC Warnings

Sometimes the objective in financing is not 'maximize overall market value' but to 'minimize the WACC.' If MM's proposition 1 holds true then they are equivalent objectives. However, if they don't, then the capital structure that maximizes the value of the firm also minimizes its WACC.

Warning 1: Shareholders want management to increase the firm's value. They are more interested in being than in owning a firm with low WACC.

Warning 2: Since shareholders demand higher expected rates of return than bondholders, therefore debt is the cheaper capital source, so WACC can be reduced by borrowing more. However, this extra borrowing leads the stockholders to demand a still higher expected rate of return.[17]

Criticisms of MM Theory

Firms are liable to pay taxes on their income.

Bankruptcy costs are quite high.

Agency costs exist because of conflict of interest between managers and shareholders.

Managers have a preference for a certain sequence of financing.

Personal leverage and corporate are not perfect substitutes.


It states that a company chooses how much debt finance and equity finance to use by balancing the costs and benefits. It states that there is an advantage to financing with debt which is the tax benefits of debt and there is a cost of financing with debt which is the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs. A firm that is optimizes its overall value focuses on the trade-off when choosing how much debt and equity to use for financing.


Different firms and different industries will have different magnitudes of costs if they encounter financial distress. With some firms, distress will result in both customers and suppliers fleeing. With other firms, the fact that a firm is close to bankruptcy will not affect customers. When a firm experiences financial distress several things can happen.

Arguments between shareholders and creditors delay the liquidation of assets. Bankruptcy cases take years to settle and during this period machineries and equipments rust and become obsolete.

Assets sold under distress conditions, fetch a price lesser than their economic value.

The legal and administrative costs associated with bankruptcy are quite high.

Managers may lower the quality of goods, give unacceptable customer service, ignore welfare in a bid to survive in the short run.


These the increased costs of financing with debt instead of equity that result in a higher probability of bankruptcy. The fact that bankruptcy is generally a costly process and not just a transfer of ownership implies that these costs negatively affect the total value of the firm. These costs can be thought of as a financial cost, because as the probability of bankruptcy increases the financial costs increases.

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It states that 'companies prioritize their sources of financing according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort'. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued. This theory prefers internal financing when available and maintains that businesses adhere to a hierarchy of financing sources and, and debt is preferred over equity if external financing is required.


'It is an economic concept that relates to the cost incurred by an organizations associated with problems such as divergent management-shareholder objectives and information asymmetry'.  The information asymmetry causes the agency problems of moral hazard and adverse selection. Agency costs mainly arise due to divergence of control, separation of ownership and control and the different objectives the managers consider.


Leverage Analysis

EBIT - EPS Analysis

ROI - ROE Analysis

Ratio Analysis

Cash Flow Analysis

Comparative Analysis

Capital Structure Policies in Practice

We will see a few in detail.


Leverage arises from the existence of Fixed Costs.

There are two kinds of Leverage:

Operating Leverage: arises from the firm's Fixed Operating costs such as salaries, depreciation, insurance, property taxes, and advertising outlays.

Financial Leverage: arises from the firm's Fixed Financing Costs such as Interest on Debt.



500 units

600 units




Variable operating costs



Fixed operating costs



Earnings before interest and taxes



Operating leverage arises from the existence of fixed operating expenses.

When a firm has fixed operating expenses, 1 percent change in unit sales leads to more than 1 percent change in EBIT.

Consider the case of a firm, XYZ Limited which is currently selling a product at Rs 1000 per unit. Its variable costs are Rs 500 per unit and its fixed operating costs are Rs 200,000. The earnings before interest and taxes at two levels of sales, viz., 500 units and 600 units, is shown below:

In the above example, a 20 percent increase in unit sales leads to a 100 percent increase in profit before interest and taxes, thanks to the existence of fixed operating costs. Hence, fixed operating costs magnify the impact of changes in revenues. This the magnification works in the reverse direction as well.

Degree of Operating Leverage

It refers to the sensitivity of PBIT (or EBIT) to changes in unit sales or Sales.


It measures the effect of change in sales revenue on the level of PBIT.

Financial leverage emanates from the existence of fixed interest expenses.

The use of fixed-charges sources of funds, such as debt and preference capital, along with owners' equity in the capital structure is known as financial leverage (or gearing or trading on equity). When a firm has fixed interest expenses, 1 percent change in profit before interest in taxes (PBIT) leads to more than 1 percent change in profit before tax (or profit after tax or earnings per share).

Consider the case of XYZ Limited, which currently has an PBIT of Rs 50,000. Its fixed interest expenses are Rs 30,000 and its tax rate is 50 percent. It has 10,000 shares outstanding. The profit before tax, profit after tax, and earnings per share for XYZ Limited at two levels of PBIT, viz., Rs 50,000 and Rs 60,000 are shown below:

Case A Case B

Profit before interest and taxes 50,000 60,000

Interest expense 30,000 30,000

Profit before tax 20,000 30,000

Tax 10,000 15,000

Profit after tax 10,000 15,000

Earnings per share 1 1.50

In the above example a 20 percent increase in PBIT leads to a 50 percent increase in profit before taxes (or PAT or EPS), thanks to the existence of fixed interest expenses. Hence, fixed interest expense magnifies the impact of changes in PBIT. The magnification works in the reverse direction as well.

Degree of Financial Leverage

It refers to the sensitivity of PBT (or PAT or EPS) to changes in PBIT.

The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners' equity.

Combined leverage, or total leverage, arises from the existence of fixed operating costs and interest expenses. Due to the existence of these fixed costs, 1 percent change in unit sales, leads to more than 1 percent change in PBT (or PAT or EPS).

Consider the case of XYZ Limited, which currently has revenues of Rs 500,000. (Rs 500 units are sold at Rs 1,000 per unit). Its variable costs are Rs 500 per unit and its fixed operating costs are Rs 200,000. Its fixed interest expenses are Rs 30,000 and its tax rate is 50 percent. It has 10,000 shares outstanding. The financial profile of the company at two levels of sales viz. 500 units (the current level) and 600 units (a level 20 percent higher than the current level) is shown below.

Sales Sales

600 units 500 units

Revenues 500,000 600,000

Variable operating costs 250,000 300,000

Fixed operating costs 200,000 200,000

PBIT 50,000 100,000

Interest 30,000 30,000

Profit before tax 20,000 70,000

Tax 10,000 35,000

Profit after tax 10,000 35,000

Earnings per share 1 3.5

In the above example, a 20 percent increase in unit sales leads to a 250 percent increase in earnings per share, due to the existence of fixed operating costs and interest expenses.

Also, fixed costs magnify the impact of changes in unit sales.

Degree of Combined Leverage

It refers to the sensitivity of PBT (or PAT or EPS) to changes in unit sales or sales.

PBIT-EPS Analysis

EPS is sensitive to changes in PBIT under different financing alternatives.


EPS = earnings per share,

EBIT = earnings before interest and taxes,

I = the interest burden,

t = the tax rate, and

n= the number of equity shares.

Break-Even PBIT Level

Consider the following data for ABC Limited.

Existing Capital Structure: 1 million equity shares of Rs. 10 each

Tax Rate : 50 percent

ABC Limited plans to raise additional capital of Rs. 10 million for financing an expansion project. In this context, it is evaluating two alternative fina


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