The document discusses capital structure and its theories. It defines capital structure as the proportion of long-term debt and equity used to finance a company's assets. A company's capital structure determines its risk and cost of capital. There are several theories on capital structure including the net income, net operating income, traditional, and Modigliani-Miller approaches. The optimal capital structure balances minimum costs and risks. Factors like tax rates, control, flexibility, and legal requirements influence a company's choice of capital structure.

1. STRUCTUR
E
Presentation by:
JEENIA(2)
AARTI (32)
NEHA(34)
SHEENU(36)

2. MEANING OF CAPITAL STRUCTURE
Capital structure refer to the proportion between the
various long term source of finance in the total
capital of firm
A financial manager choose that source of finance
which include minimum risk as well as minimum
cost of capital.

3. Sources of
long term
finance
Proprietor’s
funds
Equity
capital
Preference
capital
Reserve
and surplus
Borrowed
funds
Long term
debts

4.  Capital structure determine the risk assumed by the
firm
 Capital structure determine the cost of capital of the
firm
 It affect the flexibility and liquidity of the firm
 It affect the control of the owner of the firm

5.  Nature and Size of the firm
 Stability of the earning
 Stages of life cycle of the firm
 Cash flow ability of the firm
 Cost of capital

6.  Rate of corporate tax
 Retaining control
 Flexibility
 Trading on equity
 Legal requirement
 Assets structure
 Nature of investor

7. It refer to that EBIT level, at which EPS remain
same irrespective of different alternatives of debt-
equity mix.
At this level of EBIT return on capital employed is
equal to cost of debt this is also known as break
even level of EBIT for alternative financial plan

8. (X-I1)(1-T)-PD = (X-I2)(1-T)-PD
S1 S2
Where
 X = point of indifference
 I1 = int. under alternative financial plan 1
 I2= int. under alternative financial plan 2
 T = tax rate
 PD = pref. dividend
 S1 = amount of equity share under financial plan 1
 S2= amount of equity share under financial plan 2

10. Net income
approach
Net operating
income approach
Traditional approach
Modigliani and miller
approach
Capital
structure
theories

11. NET INCOME (NI) THEORIES
 This theory is suggested by “David Durand”
 Acc. to this approach the value of the firm is
increase and decrease overall cost of capital by
increasing the proportion of debt financing in capital
structure
 It is due to the fact that debt is generally a cheaper
sources of finance because:
1. Interest rate are lower than the dividend rate
2. Benefit of tax because int. is deductible
expense

12. ASSUMPTION OF NET INCOME
APPROACH
 The cost of debt is lower than cost of equity
 The risk perception of the investor is not changed
by the use of debt
 There is no corporate tax

13.  hg

14. NET OPERATING INCOME APPROACH
 This theory was propounded by “David Durand” and
is also known as irrelevant theory.
 Acc. to this theory, the total market value of the firm
is not affected by the change in the capital structure
and the overall cost of capital remain constant
irrespective of debt-equity ratio.

15. ASSUMPTION OF NET OPERATING INCOME
APPROACH
 The market capitalizes the value of the firm as a
whole. Thus, the split between debt and equity is
not important
 The cost of debt is lower than cost of equity
 The risk perception of the investor is not changed
by the use of debt
 There is no corporate tax

17. TRADITIONALAPPROACH
 This approach is the midway of NI approach and NOI
approach. And also known as intermediate approach.
 Acc. to this, the value of firm can be increased initially or
cost of capital can be decreased by using more debt as the
debt is a cheaper source of fund than equity
After that optimum capital structure can be reached by a
proper debt-equity mix
But after a particular point if the proportion of debt is
increased, then the overall cost of capital start increasing
and market value begin to decline

19. MODIGLIANI-MILLER APPROACH
 They have given two approach
1. In the absence of corporate taxes
2. When corporate taxes exist

20. Assumption :-
 Capital market are perfect
 Homogeneous risk classes of firm
 Expectations about the net operating income
 100% payout ration
 No corporate tax

21. IN THE ABSENCE OF CORPORATE TAXES
Acc. To this theory total value of a firm must be
constant irrespective of degree of leverage, i.e.
debt-equity ratio. This can be justified by arbitrage
process .
This approach is similar to the net operating income
approach when taxes are ignored
It means capital structure decision of a firm is not
affect its market value.

22. WHEN CORPORATE TAX ARE ASSUMED TO
EXIST
Acc. to this value of the firm increase and cost of
capital decrease with the use of debt if corporate
tax are considered. This is because of Benefit of tax
because int. on tax is deductible expense

23.  Optimum capital structure is a capital
structure at which market value per
share is maximum and the cost of
capital is minimum

24. Simplicity
flexibility
Minimum risk
Minimum cost of capital
Sufficient liquidity
Retaining control
Avoidance of unnecessary restriction

25.  EPS = (EBIT-I)(I-t)-PD
n
Where :
EPS = earning per share
EBIT = earning before int. and tax
I = int. charged per annum
t = tax rate
PD = preference dividend
n = no. of equity shares

26. Q-ABC company has currently an all equity structure
consisting of 15000 equity shares of rs.100 each. The
management is planning to raise another rs.25 lakhs to
finance a major programme of expansion and it consider
three alternative method of financing
 To issue 25000 equity share of rs.100 each
 To issue 25000, 8% debenture of rs.100 each
 To issue 25000, preference share of rs.100 each
the company EBIT will be 8 lakhs. Assuming a corporate
tax of 50%, determine earning per share in each alternative

27. Alternative 1
equity financing
Alternative 2 debt
financing
Alter. 3 pref. share
financing
EBIT 8.00 8.00 8.00
Less int. - 2.00 -
Earning after int. but
before tax
8.00 6.00 8.00
Less tax @50% 4.00 3.00 4.00
EAT 4.00 3.00 4.00
Less pref. dividend - - 2.00
E available to equity
shareholders
4.00 3.00 2.00
No. of equity share 40000 15000 15000
400000 300000 200000
EPS Rs.10 Rs.20 Rs.13.33

28.  Goel DK, Management accounting and financial
management, APC
 Gupta Shashi K., financial management and policy,
kalyani publication