Capital Structure – Definition, Theories and Approach

Capital structure is the combination of capitals from different sources of finance.

Net Operating Income (NOI) Theory of Capital Structure

According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.

Assumptions:

1. 1. The corporate income taxes do not exist.
   2. Debt Equity mix is irrelevant for computation of market value of firm.
   3. With the increase in debt proportion, financial risk and expectations of shareholders increase.
   4. The overall cost of capital (K_o) remains constant for all degrees of debt equity mix.

Fundamental Principles Governing Capital Structure are:

1. Financial leverage or Trading on Equity

Debt is cheaper source of finance and interest is also allowed expense as per tax. When a firm raise funds through long-term fixed interest bearing debt and preference share capital along with equity share capital, EPS will increase if cost of fixed funds is lower than rate of return earned by firm. It is called as favourable leverage situation. If cost of fixed fund is higher than rate of return then leverage work adversely. Therefore, it needs caution to plan the capital structure of a firm.

2. Growth and stability of sales

Growth and stability of sales is most important factor to decide capital structure. Firm with stable sale can raise higher amount of debt because with stable revenue we can easily pay debt. Similarly, the rate of the growth in sales also provides confidence to management that they can easily pay interest and principal on time. With greater rate of growth of sales, firm can raise funds through debt. If sales of any firm is fluctuating then firm should not go with debt finance.

3. Cost Principle

As per cost principle, optimum capital structure is that debt equity mix at which cost of capital is lowest and market value of firm is highest.

4. Risk Principle

Due to commitment of fixed payment, debt is a risky source of finance and equity is non-risky source. Higher proportion of debt and accordingly higher risk is not recommended.

5. Control Principle

If we raise additional funds through issue of equity shares then control over company of existing shareholders will be diluted. Existing management control and ownership remains undisturbed with debt finance.

6. Flexibility Principle

Firm should arrange funds in an efficient manner so that we can increase or decrease company’s fund base according to requirement.

7. Other Considerations

Other factors such as nature of business, market situation, existing and future market scenario, government policies, timing of issue and competition in market etc. should also be considered.

Over capitalization: It is a situation where a firm has excess capital or funds are higher than requirement. In this situation assets are worth less than its issued share capital, and earnings are not sufficient to pay dividend and interest.

Causes of Over Capitalization

1. 1. Raising higher amount through issue of shares or debentures than company needs.
   2. Raising higher amount of debt at higher rate than rate at which company can earn.
   3. Huge payment for the acquisition of fictitious assets like high payment is made to purchase goodwill etc.
   4. Provision for depreciation is not made properly.
   5. Payment of dividend with high rate.
   6. Estimation of earnings and capitalization was wrong.

Consequences of Over-Capitalisation

1. 1. Decrease in the rate of dividend and interest payments.
   2. Decrease in the market price of shares.
   3. Decrease in market value of firm.
   4. Firm may use window dressing.
   5. Reorganisation of company.
   6. Liquidation in worst scenario.

Capital structure

Capital structure refers to the combination of funds from different sources of finance. Company can arrange funds through equity share capital, retained earnings, preference share capital and long term debts.

Significance

The primary objective of any firm is wealth maximisation. Value of any firm is calculated by capitalisation of it’s after tax earnings. Cost of capital is used as rate of capitalisation. Lower rate of cost of capital leads higher market value of firm and cost of capital is lowest at optimum capital structure. So capital structure is relevant in maximizing value of the firm and minimizing overall cost of capital. To finance any investment or arrange any single rupee, firm has to take capital structure decision.