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Assignment
Topic: Capital structure
determinants

Muhammad Minhas Azeem

Msc Applied Chemistry
Department of Applied Chemistry and Biotechnology
GC University Faisalabad, Pakistan

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Capital structure and its Determinants

Definition
The capital structure of a firm is the mix of different securities issued by the firm to finance its
operations.
Securities
Bonds, bank loans
Ordinary shares (common stock), Preferenceshares (preferred stock)
Hybrids, e.g. warrants, convertible bonds

Sources of Capital

Ordinary shares (common stock)

Preference shares (preferred stock)
Hybrid securities
Warrants
Convertible bonds
Loan capital
Bank loans
Corporate bonds

Ordinary shares (common stock)

Risk finance
Dividends are only paid if profits are made and only after other claimants have been paid
e.g. lenders and preference shareholders
A high rate of return is required
Provide voting rights the power to hire and fire directors
No tax benefit, unlike borrowing

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Preference Share
Lower risk than ordinary shares and a lower dividend
Fixed dividend - payment before ordinary shareholders and in a liquidation situation
No voting rights - unless dividend payments are in arrears
Cumulative - dividends accrue in the event that the issuer does not make timely
dividend payments
Participating - an extra dividend is possible
Rredeemable - company may buy back at a fixed future date
Determinants of Capital structure
Capital structure should be designed very carefully.
Management of the company should set a target capital structure and the subsequent
financing decisions should be made with a view to achieve the target capital structure.
Once a company has been formed and it has been in existence for some years, the
financial manager then has to deal with the existing capital structure.
The company may need funds to finance its activities continuously.
Every time the funds have to be procured, the financial manager weighs the pros and
cons of various sources of finance and selects most advantageous sources keeping in
view the target capital structure:

Thus the capital structure decision is a continuous one and has to be

taken whenever a firm needs additional finance.
The factors to be considered whenever a capital structure decision is taken are

Financial Leverage
Growth & Stability of Sales
Cost of Capital
Cash Flow Ability to Service Debt
Nature & Size of a Firm
Control
Flexibility
Requirements of Investors

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Capital Market Conditions

Assets Structure
Purpose of Financing
Period of Finance
Costs of Floatation
Personal Considerations
Corporate Tax Rate
Legal Requirements

Financial Leverage:
The degree to which an investor or business is utilizing borrowed money.
Companies that are highly leveraged may be at risk of bankruptcy if they are unable
to make payments on their debt they may also be unable to find new lenders in the future
Financial leverage is not always bad, however; it can increase the shareholders' return on
investment and often there are tax advantages associated with borrowing also called leverage.

Growth & Stability of Sales

Stability of sales ensures that the firm will not face any difficulty in meeting its fixed
commitments of interest payment & repayment of debt.

Usually, greater the rate of growth in sales, greater can be the use of debt in the
financing of firm.

On the other hand, if the sales of a firm are highly fluctuating or declining, it should not
employ, as far as possible, debt financing in its capital structure.

Cost of capital
Cost of funds used for financing a business.
Cost of capital depends on the mode of financing used
It refers to the cost of equity if the business is financed

solely through equity,

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Cost of debt if it is financed solely through debt.

Companies use a combination of debt and equity to finance their businesses, and for such
companies, their overall cost of capital is derived from a weighted average of all capital
sources, widely known as the weighted average cost of capital (WACC).
cost of capital represents a hurdle rate that a company must overcome before it can
generate value.

It is extensively used in the capital budgeting process to determine whether the company
should proceed with a project.

Cash flow
A measure of a company's financial health.

Equals cash receipts minus cash payments over a given period of time; or
equivalently, net profit plus amounts charged off for depreciation, depletion,
and amortization.

The companies which expect large and stable cash inflows

of debt in their capital structure.

can employ a large amount

It is somewhat risky to employ sources of capital with fixed charges for companies
whose cash inflows are unstable or unpredictable.

A revenue or expense stream that changes a cash account over a given period. Cash
inflows usually arise from one of three activities - financing, operations or investing although this also occurs as a result of donations or gifts in the case of personal finance.
Cash outflows result from expenses or investments. This holds true for both business and
personal finance.
It is somewhat risky to employ sources of capital with fixed charges for companies whose
cash inflows are unstable or unpredictable.
A revenue or expense stream that changes a cash account over a given period. Cash
inflows usually arise from one of three activities - financing, operations or investing although this also occurs as a result of donations or gifts in the case of personal finance.
Cash outflows result from expenses or investments. This holds true for both business and
personal finance.
A revenue or expense stream that changes a cash account over a given period.
Cash inflows usually arise from one of three activities - financing, operations or
investing - although this also occurs as a result of donations or gifts in the case of
personal finance.

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Cash outflows result from expenses or investments. This holds true for both business and
personal finance.
Nature & Size of a Firm
Public utility concerns may employ more of debt because of stability & regularity of their
earnings.
a concern which cannot provide stable earnings due to the nature of its business will have
to rely mainly on equity capital.
Small companies have to depend mainly upon owned capital as it is very difficult for
them to raise long-term loans on reasonable terms.

Control
Whenever additional funds are required by a firm, the management of the firm wants to
raise the funds without any loss of control over the firm.
The control of the existing shareholders is diluted. Hence, they might raise the additional
funds by way of fixed interest bearing debt & preference share capital.
Preference shareholders & debentures holders do not have the voting right. Hence, from
the point of view of control, debt financing is recommended.

Flexibility
Capital structure should be as capable of being adjusted according to the needs of
the changing conditions.
It should be in such a manner that it can substitute one form of financing by
another. Redeemable preference shares & convertible debentures may be preferred on
account of flexibility.

Requirements of Investors
It is necessary to meet the requirements of both institutional as well as private investors
when debt financing is used.
Investors are generally classified under three kinds. i:e. Bold investors, Cautious
investors & Less cautious investors.

Capital Market condition

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Capital market conditions do not remain the same for ever. Sometimes there may be
depression while at other times there may be boom in the market.
Securities is also influenced by the market conditions.
Share market is depressed & there are pessimistic business conditions, the company
should not issue equity shares as investors would prefer safety. But in case there is boom
period, it would be advisable to issue equity shares.

Asset Structure
The liquidity & the composition of assets should also be kept in mind while selecting the
capital structure.
If fixed assets constitute a major portion of the total assets of the company, it may be
possible for the company to raise more of long term debts.

Purpose of Financing
If funds are required for a productive purpose, debt financing is suitable & the company
should issue debentures as interest can be paid out of the profits generated from the
investment.
If the funds are required for unproductive purpose or general development on permanent
basis, we should prefer equity capital.

Period of Finance
Period for which the finances are required is also an important factor to be kept in mind
while selecting an appropriate capital mix.
If the finances are required for a limited period of, seven years, debentures should be
preferred to shares.
In case funds are needed on permanent basis, equity share capital is more appropriate.

Cost of Flotation
Although not very significant, yet costs of floatation of various kinds of securities should
also be considered while raising funds.
The cost of floating a debt is generally less than the cost of floating an equity & hence it
may persuade the management to raise debt financing.

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The costs of floating as a percentage of total funds decrease with the increase in size of
the issue.
Personal consideration
The personal considerations & abilities of the management will have the final say on the
capital structure of a firm.
Managements which are experienced & are very enterprising do not hesitate to use more
of debt in their financing as compared to the less experienced & conservative
management.
Corporate Tax Rate
High rate of corporate taxes on profits compel the companies to prefer debt financing,
because interest is allowed to be deducted while computing taxable profits.
On the other hand, dividend on shares is not an allowable expense for that purpose.
Legal requirements
The government has also issued certain guidelines for the issue of shares & debentures.
The legal restrictions are very significant as these lay down a framework within which
capital structure decision has to be made.

Capital structure theories

1- Net Income Approach (NI)

Suggested by Durand
It says a change in the capital structure will lead to a corresponding change in the overall
cost of capital as well as the total value of the firm
If the ratio of debt to equity is increased, the weighted average cost of capital will
decline, while the value of the firm will increase and vice versa
Assumptions:
1. There are no taxes
2. That the cost of debt is less than the equity capitalization rate or cost of equity
3. That the use of debt does not change the risk-perception of investors.

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2- Net operating Income (NOI) Approach

Also suggested by durand
This approach is diametrically opposite to the net income approach
Any change in leverage or debt will not lead to any change in the total value of the firm
as the overall cost of capital is independent of the degree of leverage
The significant feature is that the equity capitalization rate, increases with the increase in
the degree of leverage. The equity capitalization rate decreases with the decrease in the
degree of leverage.
3-Modigliani-Miller (MM) Approach
Suggested by Modigliani Miller
MM is similar to NOI approach
It suggests that the cost of capital of the firm is an independent factor and has no concern
with the capital structure
This theory implies that any change in capital structure of the concern does not affect the
cost of capital.
4-Traditional Approach
This approach is a mid way between NI approach and NOI approach.