Prof.P.S.

Ravindra

UNIT-II
FINANCING DECISION

INTRODUCTION
Business requires finance for many purposes. First a large sum of money has to be spent
on investigating the soundness of a business scheme before it is taken up for implementation. If
the scheme is large and is organized as a joint stock company, drafting and printing of necessary
documents, registration of the company etc. involve expenses. All these have to be done before
the commencement of business. Secondly in the case of a manufacturing organization a factory
building has to be erected and machinery installed before production can be undertaken. Thirdly,
money is needed to purchase raw materials semi-finished parts and miscellaneous stores and to
pay the workers. Finally the procurement of money itself involves some expense. It is incurred
on advertising, preparation of documents, maintenance of books and staff for the purpose,
payment of interest, creation of funds for repayment and so on.
SOURCES OF FINANCE OF A BUSINESS
Sources of finance mean the ways for mobilizing various terms of finance to the
industrial concern. Sources of finance state that, how the companies are mobilizing finance for
their requirements. The companies belong to the existing or the new which need sum amount of
finance to meet the long-term and short-term requirements such as purchasing of fixed assets,
construction of office building, purchase of raw materials and day-to-day expenses.
Sources of Finance may be classified as:
(I) Long term Sources and
(II) Short term Sources.
(I) LONG TERM SOURCES:
When the finance mobilized with large amount and the repayable over the period will be
more than five years, it may be considered as long-term sources. Share capital, issue of
debenture, long-term loans from financial institutions and commercial banks come under this
kind of source of finance. Long-term source of finance needs to meet the capital expenditure of
the firms such as purchase of fixed assets, land and buildings, etc. Long-term sources of finance
include:
(a) Equity Shares
(b) Preference Shares
(c) Debenture
(d) Public Deposits
(e) Retained Earnings
(f) Term Loans
(g) Loans from Financial Institutions
(h) Lease and Hire Purchase
(a) Equity Shares:
Equity Shares also known as ordinary shares, which means, other than preference shares. Equity
shareholders are the real owners of the company. They have a control over the management of
the company. Equity shareholders are eligible to get dividend if the company earns profit. Equity
share capital cannot be redeemed during the lifetime of the company. The liability of the equity
shareholders is the value of unpaid value of shares.
Features of Equity Shares
Equity shares consist of the following important features:
1. Maturity of the shares: Equity shares have permanent nature of capital, which has no
maturity period. It cannot be redeemed during the lifetime of the company.
 [Link]

2. Residual claim on income: Equity shareholders have the right to get income left after paying
fixed rate of dividend to preference shareholder. The earnings or the income available to the
shareholders is equal to the profit after tax minus preference dividend.
3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders
have the right to get the claims on assets. These rights are only available to the equity
shareholders.
4. Right to control: Equity shareholders are the real owners of the company. Hence, they have
power to control the management of the company and they have power to take any decision
regarding the business operation.
5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the
help of voting right power; they can change or remove any decision of the business concern.
Equity shareholders only have voting rights in the company meeting and also they can nominate
proxy to participate and vote in the meeting instead of the shareholder.
(b) Preference Shares
The parts of corporate securities are called as preference shares. It is the shares, which have
preferential right to get dividend and get back the initial investment at the time of winding up of
the company. Preference shareholders are eligible to get fixed rate of dividend and they do not
have voting rights.
Features of Preference Shares
The following are the important features of the preference shares:
1. Maturity period: Normally preference shares have no fixed maturity period except in the
case of redeemable preference shares. Preference shares can be redeemable only at the time of
the company liquidation.
2. Residual claims on income: Preferential sharesholders have a residual claim on income.
Fixed rate of dividend is payable to the preference shareholders.
3. Residual claims on assets: The first preference is given to the preference shareholders at the
time of liquidation. If any extra Assets are available that should be distributed to equity
shareholder.
4. Control of Management: Preference shareholder does not have any voting rights. Hence,
they cannot have control over the management of the company.
(c) Debentures
A Debenture is a document issued by the company. It is a certificate issued by the
company under its seal acknowledging a debt. According to the Companies Act 1956,
“debenture includes debenture stock, bonds and any other securities of a company whether
constituting a charge of the assets of the company or not.”
Features of Debentures
1. Maturity period: Debentures consist of long-term fixed maturity period. Normally,
debentures consist of 10–20 years maturity period and are repayable with the principle
investment at the end of the maturity period.
2. Residual claims in income: Debenture holders are eligible to get fixed rate of interest at
every end of the accounting period. Debenture holders have priority of claim in income of the
company over equity and preference shareholders.
3. Residual claims on asset: Debenture holders have priority of claims on Assets of the
company over equity and preference shareholders. The Debenture holders may have either
specific change on the Assets or floating change of the assets of the company. Specific change of
Debenture holders are treated as secured creditors and floating change of Debenture holders are
treated as unsecured creditors.
4. No voting rights: Debenture holders are considered as creditors of the company. Hence they
have no voting rights. Debenture holders cannot have the control over the performance of the
business concern.
 [Link]

5. Fixed rate of interest: Debentures yield fixed rate of interest till the maturity period. Hence
the business will not affect the yield of the debenture.
(d) Public Deposits:
It is a very old source of finance in India. When modern banks were not there, people
used to deposit their savings with business concerns of good repute. Even today it is a very
popular and convenient method of raising medium term finance. The period for which business
undertakings accept public deposits ranges between six months to three years.
Procedure to raise funds through Public Deposits:
An undertaking which wants to raise funds through public deposits advertises in the
newspapers. The advertisement highlights the achievements and future prospects of the
undertaking and invites the investors to deposit their savings with it. It declares the rate of
interest which may vary depending upon the period for which money is deposited. It also
declares the time and mode of payment of interest and the repayment of deposits. A depositor
may get his money back before the date of repayment of deposits for which he will have to give
notice in advance.
Features:
1. These deposits are not secured.
2. They are available for a period ranging between 6 months and 3 years.
3. They carry fixed rate of interest.
4. They do not require complicated legal formalities as are required in the case of shares or
debentures.
(e) Retained earnings:
Like an individual, companies also set aside a part of their profits to meet future
requirements of capital. Companies keep these savings in various accounts such as General
Reserve, Debenture Redemption Reserve and Dividend Equalization Reserve etc. These reserves
can be used to meet long term financial requirements. The portion of the profits which is not
distributed among the shareholders but is retained and is used in business is called retained
earnings or ploughing back of profits. As per Indian Companies Act., companies are required to
transfer a part of their profits in reserves. The amount so kept in reserve may be used to buy
fixed assets. This is called internal financing.
(f) Term loans from banks:
Many industrial development banks, cooperative banks and commercial banks grant
medium term loans for a period of three to five years. Traditionally, commercial banks in India
do not grant long term loans. They grant loans only for short period not extending one year. But
recently they have started giving loans for a long period. Commercial banks give term loans i.e.
for more than one year. The period of repayment of short term loan is extended at intervals and
in some cases loan is given directly for a long period. Commercial banks provide long term
finance to small scale units in the priority sector.
(g) Loan from financial institutions:
There are many specialized financial institutions established by the Central and State
governments which give long term loans at reasonable rate of interest. Some of these institutions
are: Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India
(IDBI), Industrial Credit and Investment Corporation of India (ICICI), Unit Trust of India (UTI),
and State Finance Corporations etc.
(h) Lease and Hire Purchase:
Instead of procuring funds, and purchasing the equipment, a firm can acquire the asset
itself on lease. In this case, the asset is financed by the lessor but the lessee gets the asset for use.
Incase of hire purchase, the assets are acquired on credit and payments are made as per terms and
conditions.
 [Link]

(II) SHORT TERM SOURCES:

After establishment of a business, funds are required to meet its day to day expenses. For
example raw materials must be purchased at regular intervals, workers must be paid wages
regularly, water and power charges have to be paid regularly. Thus there is a continuous
necessity of liquid cash to be available for meeting these expenses. For financing such
requirements short-term funds are needed. The availability of short-term funds is essential.
Inadequacy of short-term funds may even lead to closure of business.
Short-term finance serves following purposes
It facilitates the smooth running of business operations by meeting day to day financial
requirements.
2. It enables firms to hold stock of raw materials and finished product.
3. With the availability of short-term finance goods can be sold on credit. Sales are for a certain
period and collection of money from debtors takes time. During this time gap, production
continues and money will be needed to finance various operations of the business.
4. Short-term finance becomes more essential when it is necessary to increase the volume of
production at a short notice.
5. Short-term funds are also required to allow flow of cash during the operating cycle. Operating
cycle refers to the time gap between commencement of production and realization of sales.
Sources of Short-term Finance
There are a number of sources of short-term finance which are listed below:
a) Trade credit
b) Bank credit
c) Commercial Papers
d) Customers’ Advances
e) Inter-corporate Deposits (ICDs)
f) Short-term Unsecured Debentures
(a) Trade Credit:
Trade credit refers to credit granted to manufactures and traders by the suppliers of raw
material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to
90 days credit. This means that the goods are delivered but payments are not made until the
expiry of period of credit. This type of credit does not make the funds available in cash but it
facilitates purchases without making immediate payment. This is quite a popular source of
finance.
(b) Bank Credit:
Credit facility provided by commercial banks to meet the short-term and working capital
requirements has been important short term sources of finance in India. The bank credit, in
general, is a short, term financing, say, for a year or so. This short-term financing to business
firm is regarded as self-liquidating in the sense that the uses to which the borrowing firm is
expected to put the funds are ordinarily expected to generate cash flows adequate to repay the
loan within a year. Further, these loans are called self-liquidating because the bank’s motive to
provide finance is to meet the seasonal demand, e.g., to cover the seasonal increase in inventories
or receivables. In principle, the bank credit is intended to carry the firm through seasonal peaks
in financing need. The amount of credit extended by a bank may be referred to as a credit limit
which denotes the maximum limit of loan which the firm can avail from the bank. Sometimes,
the bank may approve separate limits for peak season and non-peak season.
(c) Commercial Papers:
Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds
for a short period, generally, varying from a few days to a few months. For example, in India, the
maturity period of CP varies between 15 days to 1 year while in some other countries, the
maturity period may go up to 270 days. It is a money market instrument and generally purchased
 [Link]

by commercial banks, money market mutual funds and other financial institutions desirous to
invest their funds for a short period.
(d) Customers’ Advances:
Sometimes businessmen insist on their customers to make some advance payment. It is
generally asked when the value of order is quite large or things ordered are very costly.
Customers’ advance represents a part of the payment towards price on the product (s) which will
be delivered at a later date. Customers generally agree to make advances when such goods are
not easily available in the market or there is an urgent need of goods. A firm can meet its short-
term requirements with the help of customers’ advances.
(e) Inter-corporate Deposits (ICDs)
Sometimes, the companies borrow funds for a short-term period, say up to six months,
from other companies which have surplus liquidity for the time being. The ICDs are generally
unsecured and are arranged by a financier. The ICDs are very common and popular in practice as
these are not marred by the legal hassles. The convenience is the basic virtue of this method
of financing. There is no regulation at present in India to regulate these ICDs. Moreover, these
are not covered by the Section 58A of the Companies Act, 1956, as the ICDs are not for long
term. The transactions in the ICD are generally not disclosed as the borrowing under the ICDs
imply a liquidity shortage of the borrower. The rate of interest on ICDs varies depending upon
the amount involved and the time period. The entire working of ICDs market is based upon the
personal connections of the lenders, borrowers and the financiers.
(f) Short-term Unsecured Debentures:
Companies have raised short-term funds by the issue of unsecured debentures for periods
upto 17 months and 29 days. The rate of interest on these debentures may be higher than the rate
on secured long-term debentures. It may be noted that no credit rating is required for the issue of
these debentures because as per the SEBI guidelines, the credit ratings required for debentures
having maturity period of 18 months or more. The use of unsecured debentures as a source of
short-term financing, however, depends upon the state of capital market in the economy. During
sluggish period, the companies may not be in a position to issue these debentures. Moreover,
only established firms can issue these debentures as new company will not find favour from the
investors. Another drawback of this source is that the company pro-cures funds from retail
investors instead of getting a lump-sum from one source only. Further, that the issue of securities
in capital market is a time consuming process and the issue must be planned in a proper way.
COST OF CAPITAL
Cost of capital is an integral part of investment decision as it is used to measure the worth of
investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the
firms are using different sources of finance, the finance manager must take careful decision with
regard to the cost of capital; because it is closely associated with the value of the firm and the
earning capacity of the firm.
Meaning of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to
maintain its market value and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity,
debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of
the shares will fall and it will result in the reduction of overall wealth of the shareholders.
Definitions
The following important definitions are commonly used to understand the meaning and concept
of the cost of capital.
 [Link]

According to the definition of John J. Hampton “ Cost of capital is the rate of return the
firm required from investment in order to increase the value of the firm in the marketplace”.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required
rate of earnings or the cut-off rate of capital expenditure”.
According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for
the allocation of capital to investment of projects. It is the rate of return on a project that will
leave unchanged the market price of the stock”.
According to the definition of William and Donaldson, “Cost of capital may be defined
as the rate that must be earned on the net proceeds to provide the cost elements of the burden at
the time they are due”.
IMPORTANCE OF COST OF CAPITAL
Computation of cost of capital is a very important part of the financial management to decide the
capital structure of the business concern.
1. Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According
to net present value method, present value of cash inflow must be more than the present value of
cash outflow. Hence, cost of capital is used to capital budgeting decision.
2. Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities. A
firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps
to take decision regarding structure.
3. Importance to Evolution of Financial Performance
Cost of capital is one of the important determining which affects the capital budgeting,
capital structure and value of the firm. Hence, it helps to evaluate the financial performance of
the firm.
4. Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as,
market value of share, earning capacity of securities etc. hence, it plays a major part in the
financial management.
Classification of cost of capital:
Cost of capital may be classified into the following types on the basis of nature and usage:
• Explicit and Implicit Cost.
• Average and Marginal Cost.
• Historical and Future Cost.
• Specific and Combined Cost.
Explicit and Implicit Cost
The cost of capital may be explicit or implicit cost on the basis of the computation of cost of
capital. Explicit cost is the rate that the firm pays to procure financing. This may be calculated
with the help of the following equation;
n
CIo = ∑ COt
t=1
(t+C)t
Where,
CIo = initial cash inflow C = outflow in the period concerned
N = duration for which the funds are provided T = tax rate
Implicit cost is the rate of return associated with the best investment opportunity for the
firm and its shareholders that will be forgone if the projects presently under consideration by the
firm were accepted.
 [Link]

Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital
employed by the company. It considers weighted average cost of all kinds of financing such as
equity, debt, retained earnings etc.
Marginal cost is the weighted average cost of new finance raised by the company. It is
the additional cost of capital when the company goes for further raising of finance.
Historical and Future Cost
Historical cost is the cost which as already been incurred for financing a particular
project. It is based on the actual cost incurred in the previous project. Future cost is the
expected cost of financing in the proposed project. Expected cost is calculated on the basis of
previous experience.
Specific and Combine Cost
The cost of each sources of capital such as equity, debt, retained earnings and loans is
called as specific cost of capital. It is very useful to determine the each and every specific source
of capital.
The composite or combined cost of capital is the combination of all sources of capital. It
is also called as overall cost of capital. It is used to understand the total cost associated with the
total finance of the firm.
MEASUREMENT OF COST OF CAPITAL
It refers to the cost of each specific sources of finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
(A) Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the
firm to determine its share value.
Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return that a
firm must earn on the equity financed portion of an investment project in order to leave
unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
Dividend Price Approach
The cost of equity capital will be that rate of expected dividend which will maintain the present
market price of equity shares.
Dividend price approach can be measured with the help of the following formula:

D
Ke =
P
Where,
Ke = Cost of equity capital
D = Dividend per equity share
P = Net proceeds of an equity share
Dividend Price Plus Growth Approach
The cost of equity is calculated on the basis of the expected dividend rate per share plus
growth in dividend. It can be measured with the help of the following formula:
 [Link]

D
Ke = +g
P
Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
P = Net proceeds of an equity share
Earning Price Approach
Cost of equity determines the market price of the shares. It is based on the future earning
prospects of the equity. The formula for calculating the cost of equity according to this approach
is as follows.
E
Ke = × 100
P
Where,
Ke = Cost of equity capital
E = Earning per share
P = Net proceeds of an equity share.
(B) Cost of debt:
Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be
issued at par, at premium or at discount and also it may be perpetual or redeemable. It may be
calculated with the help of the following formula.
Kd = R (1 – t)
Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
(C) Cost of Preference Share Capital
Cost of preference share capital is the annual preference share dividend by the net
proceeds from the sale of preference share.
There are two types of preference shares irredeemable and redeemable. Cost of
redeemable preference share capital is calculated with the help of the following formula:
Dp
Kp = × 100
P
Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
P = Net proceeds of a Preference Share
(D) Cost of Retained Earnings
Retained earnings are one of the sources of finance for investment proposal; it is different
from other sources like debt, equity and preference shares. Cost of retained earnings is the same
as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the
cost of equity capital. Cost of retained earnings can be calculated with the help of the following
formula:
Kr =Ke (1 – t) (1 – b)
Where,
Kr=Cost of retained earnings
Ke=Cost of equity
 [Link]

t=Tax rate
b=Brokerage cost
MEASUREMENT OF OVERALL COST OF CAPITAL
It is also called as weighted average cost of capital and composite cost of capital.
Weighted average cost of capital is the expected average future cost of funds over the long run
found by weighting the cost of each specific type of capital by its proportion in the firm’s capital
structure. The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the help of the following formula;
Ko= Kd Wd + Kp Wp + Ke We + Kr Wr
Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the following formula also:
∑XW
Kw =
∑W
Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance.
FACTORS AFFECTING COST OF CAPITAL
The cost of Capital is affected by a number of factors. They are divided into two categories such
as:
(A) Controllable Factors
(B) Uncontrollable Factors
(A) Controllable Factors:
1. Capital Structure Policy:
A firm has control over its capital structure, targeting an optimal capital structure. As more debt
is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.
2. Dividend Policy:
Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be
changed. For example, as the payout ratio of the company increases the breakpoint between
lower-cost internally generated equity and newly issued equity is lowered.
3. Investment Policy:
It is assumed that, when making investment decisions, the company is making investments with
similar degrees of risk. If a firm changes its investment policy relative to its risk, both the cost of
debt and cost of equity change.
(B) Uncontrollable Factors:
These are the factors affecting cost of capital that the company has no control over:
 [Link]

1. Level of Interest Rates:

The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For
example, when interest rates increase the cost of debt increases, which increases the cost of
capital.
2. Tax Rates:
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases,
decreasing the cost of capital.
Marginal Cost of Capital
The weighted average cost to a company for raising additional funds is called Marginal Cost of
Capital. The marginal cost of capital depends on the current cost of individual sources of capital
(common stock, retained earnings, preferred stock, and debt) and the proportions in which the
sources will be used. This cost is stated as a percentage and is compared to the return that is
expected to be earned on a proposed investment. The marginal weights represent the proportion
of various sources of funds to be employed in raising additional funds. MCC shall be equal to
WACC, when a firm employs the existing proportion of capital structure and some cost of
component of capital structure. But in practice WACC may not be equal to Marginal cost of
capital due to change in proportion and cost of various sources of funds used in raising new
capital. The MCC ignores the long-term implications of the new financing plans. Hence,
WACC should be preferred to maximize shareholders wealth in the long-term.
CAPITAL STRUCTURE
Capital is the major part of all kinds of business activities, which are decided by the size, and
nature of the business concern. Capital may be raised with the help of various sources. If the
company maintains proper and adequate level of capital, it will earn high profit and they can
provide more dividends to its shareholders.
Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts that make
up capitalization. It is the mix of different sources of long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term source
financing such as equity capital, preference share capital and debt capital. Deciding the suitable
capital structure is the important decision of the financial management because it is closely
related to the value of the firm.
Capital structure is the permanent financing of the company represented primarily by
long-term debt and equity.
Definition of Capital Structure
The following definitions clearly initiate, the meaning and objective of the capital
structures.
According to the definition of Gerestenbeg, “Capital Structure of a company refers to the
composition or make up of its capitalization and it includes all long-term capital resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s permanent
long-term financing represented by debt, preferred stock, and common stock equity”.
According to the definition of Presana Chandra, “The composition of a firm’s financing
consists of equity, preference, and debt”.
According to the definition of R.H. Wessel, “The long term sources of fund employed in
a business enterprise”.
Financial Structure
The term financial structure is different from the capital structure. Financial structure
shows the pattern total financing. It measures the extent to which total funds are available to
finance the total assets of the business.
 [Link]

Financial Structure = Total liabilities

Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure and capital
structure.
Financial Structure Capital Structure
1. It includes both long-term and short-term 1. It includes only the long-term sources
sources of funds of funds.
2. It means the entire liabilities side of the 2. It means only the long-term liabilities
balance sheet. of the company.
3. Financial structures consist of all sources 3. It consist of equity, preference and
of capital. retained earning capital.
4. It will not be more important while 4. It is one of the major determinations of the
determining the value of the firm value of the firm.

Optimum Capital Structure

The ratio between debt and equity is named leverage. It has to be optimized as high
leverage can bring a higher profit but create solvency risk. As above, since both hurdle rate and
cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact
the valuation. Management must therefore identify the “optimal mix” of financing – the capital
structure that results in maximum value.
The optimum capital structure has been expressed by Ezra Solomon in the following
words:
“Optimum leverage can be defined as that mix of debt and equity which will maximize
the value of a company, i.e., the aggregate value of the claims and ownership interests
represented on the credit side of the balance sheet.”
Capital structure policy involves a choice between risk and expected return. The optimal
capital structure strikes a balance between these risks and returns and thus examines the price of
the stock.
The pattern of capital structure of a firm has to be planned in such a way that the owner’s
interest is maximized. There may be three fundamental patterns of capital structure in a firm:
1. Financing exclusively by equity stock.
2. Financing by equity and preferred stock.
3. Financing by equity, preferred stock and bonds.
GUIDING PRINCIPLES OF CAPITAL STRUCTURE
Which of the above patterns would be most suited to the company can be decided in the
light of the fundamental principles. The guiding principles of capital structure decision are:
1. Cost principle:
According to this principle ideal pattern of capital structure is one that tends to minimize
cost of financing and maximize the earnings per share. Cost of capital is subject to interest rate at
which payments have to be made to suppliers of funds and tax status of such payments.
2. Risk principle:
This principle suggests that such a pattern should be devised so that the company does not run
the risk of brining on a receivership with all its difficulties and losses. Risk principle places
relatively greater reliance on common stock for financing capital requirements of the corporation
and forbids as far as possible the use of fixed income bearing securities.
 [Link]

3. Control principle:
While deciding appropriate cap ital structure the financial manager should also keep in
mind that controlling position of residual owners remains undisturbed. The use of preferred stock
and also bonds offers a means of raising capital without jeopardizing control.
4. Flexibility principle:
According to this principle, the management should strive towards achieving such
combinations of securities that the management finds it easier to maneuver sources of funds in
response to major changes in needs for funds. Not only several alternatives are open for
assembling required funds but also bargaining position of the corporation is strengthened while
dealing with the supplier of funds.
Several factors affect a company’s capital structure, and it also determines the composition of
debt and equity portions within this structure. Some of these factors are as follows:
• Business Size – The size and scale of a business affect its ability to raise finance. Small-sized
companies face difficulty in raising long-term borrowings. Creditors are hesitant to give them
loans because of the scale of their business operations. Even if they do get these loans, they have
to accept high-interest rates and stringent repayment conditions. It limits their ability to grow
their business.
• Earnings – Firms with relatively stable revenues can afford a more significant amount of debt
in their capital structure. Since debt repayment is periodical with fixed interest rates, businesses
with higher income prospects can bear these fixed financial charges. On the other hand,
companies that face higher fluctuations in their sales, like consumer goods, rely more on equity
shares to finance their operations.
• Competition: If a company operates in a business environment with more competition, it
should have more equity shares in its capital structure. Their earnings are prone to more
fluctuation compared to businesses facing lesser competition.
• Stage of the life cycle: A business in the early stage of its life cycle is more susceptible to
failure. In that case, they should use a more significant proportion of ordinary share capital to
finance their operations. Debt comes with a fixed interest rate, and it is more suitable for
companies with stable growth prospects.
• Creditworthiness: Any company that has a reputation for paying back its loans on time will
be able to raise funds on less stringent terms and at lower interest rates. It allows them to pay
back their loans on time. The opposite is true for firms that don’t have a good credit standing in
the market.
• Risk Aptitude of the Management: The attitude of a company’s management also affects
the proportion of debt and equity in the capital structure. Some managers prefer to follow a low-
risk strategy and opt for equity shares to raise finances. Other managers are confident of the
company’s ability to repay big loans, and they prefer to undertake a higher proportion of long
term debt instruments.
• Control: A management that wants outside interference in its operations may not raise funds
through equity shares. Equity shareholders have the right to appoint directors, and they also
dilute the stake of owners in the company. Some companies may prefer debt instruments to raise
funds. If the creditors get their instalments on loans and interest on time, they will not be able to
interfere in the workings of the business. But if the company defaults on their credit, the creditors
can remove the present management and take control of the business.
• State of Capital Market: The tendencies of investors and creditors determine whether a
company uses more debt or equity to finance their operations. Sometimes a company wants to
issue ordinary shares, but no one is willing to invest due to the high-risk nature of their business.
In that case, the management has to raise funds from other sources like debt markets.
• Taxation Policy: The government’s monetary policies in terms of taxation on debt and equity
instruments are also crucial. If a government levies more tax on gains from investing in the share
 [Link]

market, investors may move out of equities. Similarly, if the interest rate on bonds and other
long-term instruments is affected due to the government’s policy, it will also influence
companies’ decisions.
• Cost of Capital: The cost of raising funds depends on the expected rate of return for the
suppliers. This rate depends on the risk borne by investors. Ordinary shareholders face the
maximum risk as they don’t get a fixed rate of dividend. They get paid after preference
shareholders receive their dividends. The company has to pay interest on debentures under all
circumstances. It attracts more investors to opt for debentures and bonds.
CAPITAL STRUCTURE THEORIES
There are different viewpoints on the impact of the debt-equity mix on the shareholder’s
wealth. There is a viewpoint that strongly supports the argument that the financing decision has
major impact on the shareholder’s wealth, while according to others, the decision about the
financial decision is irrelevant as regards maximization of shareholder’s wealth.
A great deal of controversy has developed over whether the capital structure of a firm as
determined by its financing decision affects its cost of capital. Traditionalists argue that the firm
can lower its cost of capital and increase the market value per share by the judicious use of
leverage. Modigliani & Miller, on the other hand, argue that in the absence of taxes and other
market imperfections, the total value of the firm and its cost of capital are independent of capital
structure.
There are four major theories explaining the relationship between capital structure, cost
of capital and value of the firm:
1. Net Income Approach
2. Net Operating Income Approach
3. Traditional Approach
4. Modigliani-Miller Approach
There are certain underlying assumptions made in order to present the theories in a
simple manner. The assumptions are as follows:
1. The firm employs only two types of capital- debt and equity.
2. There are no corporate taxes. This assumption is removed later.
3. The firm pays 100% of its earnings as dividend.
4. The firm’s total assets are given and they do not change, i.e. the investment decisions are
assumed to be constant.
5. The firm’s total financing remains constant.
6. The operating earnings are not expected to grow.
7. The business risk remains constant and is independent of capital structure and financial risk.
8. All investors have the same subjective probability distribution of the future expected operating
earnings for a given firm.
9. The firm has a perpetual life.
1. Net Income Approach
Net Income approach suggested by the Durand. According to this approach, the capital
structure decision is relevant to the valuation of the firm. In other words, a change in the capital
structure leads to a corresponding change in the overall cost of capital as well as the total value
of the firm.
According to this approach, use more debt finance to reduce the overall cost of capital
and increase the value of firm. Net income approach is based on the following three important
assumptions:
1. There are no corporate taxes.
2. That the total capital requirement of the firm is given and remains constant.
2. The cost debt (Kd) is less than the cost of equity (Ke)
 [Link]

3. Both Kd and Ke remains constant and increase in financial leverage i.e. use of more and more
debt financing in the capital structure does not affect the risk perception of the investors.
On the other hand, if the proportion of debt financing in the capital structure is reduced or
say when the financial leverage is reduced, the weighted average cost of capital (Ko) of the firm
will increase and the total value of the firm will decrease. The Net Income (NI) Approach
showing the effect of leverage on overall cost of capital has been presented in the following
figure:

Cost of Capital (%) Ke(Cost of Equity)

Ko (Overall Cost of
Capital)

Kd (Cost of Debt)

Degree of Leverage
Figure 2.1: Net Income Approach: Effect of Leverage of Cost of Capital

The figure 2.1 shows that the Kd and Ke are constant for all levels of leverages i.e., for all levels
of debt financing. As the debt proportion or the financial leverage increases, the WACC, Ko
decreases as the Kd less than Ke. This result in the increase in value of the firm. In the Figure 4.2
it may be noted that Ko will approach Kd as the debt proportion increases. However, Ko will
never touch Kd as there cannot be a 100% debt firm. Some element of equity must be there.
However, if the firm is 100% equity firm, then the Ko is equal to Ke. The rate of decline in Ko
depends upon the relative position of Kd and Ke.
Under NI approach, the firm will have to maximum value capital structure at a point
where Ko is minimized. With a judicious use of the debt and equity, a firm can achieve an
optimum capital structure. This optimal capital structure is one at which the WACC, Ko, is
minimum resulting in the maximum value of the firm.
The total market value of a firm on the basic of Net Income Approach can be ascertained
as below:
V = S+D
Where,
V = Value of firm
S = Market value of equity
Market value of the equity can be ascertained by the following formula:
EBIT
S=
Ke
Where,
EBIT = Earnings available to Equity Shareholder
Ke = Cost of equity/Equity Capitalization Rate
D = Market Value of Debt
2. Net Operating Income (NOI) Approach:
Another modern theory of capital structure, suggested by Durand. This is just the
opposite to the Net Income approach. According to this approach, Capital Structure decision is
 [Link]

irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the
capital structure changes.
According to this approach, the change in capital structure will not lead to any change in the total
value of the firm and market price of shares as well as the overall cost of capital. NI approach is
based on the following important assumptions;
1. The investors see the firm as a whole and thus capitalizes the total earning of the firm to
find the value of the firm as a whole.
2. The overall cost of capital remains constant;
3. The cost of debt, Ke is also taken as constant.
4. The use of more and more debt in the capital structure increases the risk of the
shareholders and thus result in the increase in the cost of equity capital i.e., Ke. The
increase in Ke is such as to completely off set the benefit of employing cheaper debt, and
5. There are no corporate taxes;
The NOI approach is based on the argument that the market values the firm as a whole for a
given risk complexion. Thus, for a given value of EBIT, the value of the firm remain same
irrespective of the capital composition and instead depends on the overall cost of capital. The
value of the Equity may be found by deducting the value of debt from the total value of the firm
i.e.,
EBIT
V=
Ko
Where,
V = Value of the firm
EBIT = Earnings before interest and tax
Ko = Overall cost of capital

Ke (Cost of Equity)

Cost of Capital (%) Ko (Overall

Cost of Capital)

Kd (Cost of Debt)

Degree of Leverage
Figure 2.2: The NOI Approach: Effect of Leverage of Cost of Capital)

Figure 2.2 shows that the cost of Debt, kd, and the overall cost of capital, k0, are constant for all
levels of leverage. As the debt proportion or the financial leverage increases, the risk of the
shareholders also increases and thus the cost of equity capital, ke, is such that the overall value of
the firm remains the same. It may be noted for an all-equity firm, the ke is just equal to k0. As the
debt proportion is increased, the ke also increases. However, the overall cost of capital remains
constant because increase in ke is just sufficient to offset the benefits of cheaper debt financing.
The NOI approach considers k0 to be constant and therefore, there is no optimal capital
structure; rather every capital structure is as good as any other and so every capital structure is an
optimal one.
 [Link]

3. Traditional Approach
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is
also called as intermediate approach. According to the traditional approach, mix of debt and
equity capital can increase the value of the firm by reducing overall cost of capital up to certain
level of debt. Traditional approach states that the Ko decreases only within the responsible limit
of financial leverage and when reaching the minimum level, it starts increasing with financial
leverage.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:
1. There are only two sources of funds used by a firm; debt and shares.
2. The firm pays 100% of its earning as dividend.
3. The total assets are given and do not change.
4. The total finance remains constant.
5. The operating profits (EBIT) are not expected to grow.
6. The business risk remains constant.
7. The firm has a perpetual life.
8. The investors behave rationally.
Under the traditional approach, the cost of debt, Kd is assumed to be less than the cost of
equity, Ke. In case of 100% equity firm, Ko is equal to the Ke but when (cheaper) debt is
introduced in the capital structure and the financial leverage increases, the Ke remains same as
the equity investors expect a minimum leverage in every firm. The Ke does not increase even
with increase in leverage. The argument for Ke remaining unchanged may be that up to a
particular degree of leverage, the interest charge may not be large enough to pose a real threat to
the dividend payable to the shareholders. This constant Ke and Kd makes the Ko to fall initially.
Thus it shows that the benefits of cheaper debts are available to the firm. But this position does
not continue when leverage is further increased.
The increase in leverage beyond a limit increases the risk of the equity investors also and
as a result the Ke also starts increasing. However, the benefits of use of debt may be so large that
even after offsetting the effects of increase in Ke, the Ko may still go down or may become
constant for some degree of leverages.
However, if the firm increases the leverage further, then the risk of the debt investor may
also increase and consequently the Kd also starts increasing. The already increasing Ke and the
now increasing Kd makes the Ko to increase. Therefore, the use of leverage beyond a point will
have the effect of increase in the overall cost of capital of the firm and thus results in the
decrease in value of the firm. Figure 4.3 illustrate this approach graphically.

Ke (Cost of Equity)

Cost of Capital (%) Ko (Overall

Cost of Capital)

Kd (Cost of Debt)

Degree of Leverage
Figure 2.3: The NOI Approach: Effect of Leverage of Cost of Capital
 [Link]

The above figure suggests that there is a range of capital structure in which the cost of
capital (Ke) is the minimum and the value of the firm is maximum. There are many variations of
traditional approach, but all the supporters of the traditional approach agree that the cost of
capital declines and the value of firm increases with use of debt in capital structure.
4. Modigliani and Miller Approach
This approach was devised by Modigliani and Miller during 1950s. The fundamentals of
Modigliani and Miller Approach resemble to that of Net Operating Income Approach.
Modigliani and Miller advocates capital structure irrelevancy theory. This suggests that the
valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly
leveraged or has lower debt component in the financing mix, it has no bearing on the value of a
firm.
Modigliani and Miller Approach further states that the market value of a firm is affected
by its future growth prospect apart from the risk involved in the investment. The theory stated
that value of the firm is not dependent on the choice of capital structure or financing decision of
the firm. If a company has high growth prospect, its market value is higher and hence its stock
prices would be high. If investors do not see attractive growth prospects in a firm, the market
value of that firm would not be that great
Modigliani and Miller approach is based on the following important assumptions:
1. There is a perfect capital market.
2. There are no retained earnings.
3. There are no corporate taxes.
4. The investors act rationally.
5. The dividend payout ratio is 100%.
6. The business consists of the same level of business risk.
Value of the firm can be calculated with the help of the following formula:
EBIT
(l t)
Ke
Where
EBIT = Earnings before interest and tax
Ko = Overall cost of capital
t = Tax rate

Ke (Cost of Equity)

Cost of Capital (%) Ko (Overall

Cost of Capital)

Kd (Cost of Debt)

Degree of Leverage
Figure 2.4: MM Approach: Effect of Leverage of Cost of Capital)

The above figure indicates that as per the MM Approach, as we increase the proportion of
debt in our capital structure, overall cost of capital comes down but at the same time company
becomes financially risky, which result in increase in expectations of shareholders which leads to
 [Link]

increase in cost of equity and it will push the overall cost of capital upward. Overall Effect is
Overall Cost of Capital is constant.
Modigliani and Miller Approach: Two Propositions without Taxes
Proposition 1: With the above assumptions of “no taxes”, the capital structure does not
influence the valuation of a firm. In other words, leveraging the company does not increase the
market value of the company. It also suggests that debt holders in the company and equity share
holders have the same priority i.e. earnings are split equally amongst them.
Proposition 2: It says that financial leverage is in direct proportion to the cost of equity.
With increase in debt component, the equity shareholders perceive a higher risk to for the
company. Hence, in return, the shareholders expect a higher return, thereby increasing the cost of
equity. A key distinction here is that proposition 2 assumes that debt share holders have upper-
hand as far as claim on earnings is concerned. Thus, the cost of debt reduces.
Modigliani and Miller Approach: Propositions with Taxes (The Trade-Off Theory of
Leverage)
The Modigliani and Miller Approach assumes that there are no taxes. But in real world,
this is far from truth. Most countries, if not all, tax a company. This theory recognizes the tax
benefits accrued by interest payments. The interest paid on borrowed funds is tax deductible.
However, the same is not the case with dividends paid on equity. To put it in other words, the
actual cost of debt is less than the nominal cost of debt because of tax benefits. The trade-off
theory advocates that a company can capitalize its requirements with debts as long as the cost of
distress i.e. the cost of bankruptcy exceeds the value of tax benefits. Thus, the increased debts,
until a given threshold value will add value to a company.
This approach with corporate taxes does acknowledge tax savings and thus infers that a
change in debt equity ratio has an effect on WACC (Weighted Average Cost of Capital). This
means higher the debt, lower is the WACC.
LEVERAGES & EBIT- EPS Analysis
The term leverage refers to an increased means of accomplishing some purpose.
Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial
point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase
the return to its shareholders.
Definition of Leverage:
James Horne has defined leverage as, “the employment of an asset or fund for which the
firm pays a fixed cost or fixed return”
Types of Leverage
Leverage can be classified into three major headings according to the nature of the
finance mix of the company.

Leverage

Financial Leverage Operating Leverage

Composite Leverage

Figure 2.5: Types of Leverages

 [Link]

The company may use finance or leverage or operating leverage, to increase the EBIT and EPS.
Operating Leverage
The leverage associated with investment activities is called as operating leverage. It is caused
due to fixed operating expenses in the company. Operating leverage may be defined as the
company’s ability to use fixed operating costs to magnify the effects of changes in sales on its
earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed
cost and variable cost. When the company is said to have a high degree of operating leverage if it
employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of
operating leverage depends upon the amount of various cost structure. Operating leverage can be
determined with the help of a break even analysis.
Operating leverage can be calculated with the help of the following formula:
C
OL =
OP
Where,
OL = Operating Leverage
C = Contribution
EBIT = Earnings before Interest and Taxes
Operating leverage may be favorable or unfavorable. High degree of operating leverage
indicates higher degree of risk. It is good when revenues are rising and bad when they are
falling. Operating risk is the risk of the firm not being able to cover its fixed operating costs.
The larger the magnitude, the larger the volume of sales required to cover all fixed costs.
Before going to work out the problems, there is a need to know how to compute the earnings
available to the equity shareholders from the sales revenue.
Uses of Operating Leverage
Operating leverage is one of the techniques to measure the impact of changes in sales which lead
for change in the profits of the company.
• If any change in the sales, it will lead to corresponding changes in profit.
• Operating leverage helps to identify the position of fixed cost and variable cost.
• Operating leverage measures the relationship between the sales and revenue of the
company during a particular period.
• Operating leverage helps to understand the level of fixed cost which is invested in the
operating expenses of business activities.
• Operating leverage describes the over all position of the fixed operating cost.
The following format clearly gives a picture about the calculation of earnings available to the
ordinary shareholders.
Particulars Amount ( )
Sales Revenue (Units Sold × S.P Per Unit) ××××
Less: Variable Cost (Units Produced × CPU) ××××
Contribution ××××
Less: Fixed Cost ××××
Earnings before Interest and Taxes (EBIT) ××××
Less: Interest ××××
Earnings before Taxes (EBT) ××××
Less: Taxes ××××
Earnings after Taxes (EAT) ××××
Less: Preference Dividend ××××
Earnings available to Equity Shareholders ××××
 [Link]

Financial Leverage
Leverage activities with financing activities is called financial leverage. Financial leverage
represents the relationship between the company’s earnings before interest and taxes (EBIT) or
operating profit and the earning available to equity shareholders.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify
the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at
a fixed cost in the hope of increasing the return to the shareholders.
“The use of long-term fixed interest bearing debt and preference share capital along with share
capital is called financial leverage or trading on equity”.
Financial leverage may be favorable or unfavorable depends upon the use of fixed cost funds.
Favorable financial leverage occurs when the company earns more on the assets purchased with
the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.
Unfavorable financial leverage occurs when the company does not earn as much as
the funds cost. Hence, it is also called as negative financial leverage.
Financial leverage can be calculated with the help of the following formula:
EBIT
FL =
EBT
Where,
FL = Financial leverage
EBIT = Earnings before Interest and Taxes
EBT = Earnings before tax.
Uses of Financial Leverage
• Financial leverage helps to examine the relationship between EBIT and EPS.
• Financial leverage measures the percentage of change in taxable income to the percentage
change in EBIT.
• Financial leverage locates the correct profitable financial decision regarding capital
structure of the company.
• Financial leverage is one of the important devices which is used to measure the fixed cost
proportion with the total capital of the company.
• If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets,
the earning per share and return on equity capital will decrease.
DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE
Features of Difference Operating Leverage Financial Leverage
[Link]/Arises Operating Leverage arises Financial Leverage arises from
from the cost structure the capital Structure.
[Link] It is determined by the It is determined by the
relationship between Sales and relationship between EBIT and
EBIT EPS.
[Link] Degree of Operating leverage Degree of financial leverage
creates Business Risk. creates financial Risk.
4. Formula Used DOL=Sales-VC/EBIT DFL=EBIT/EBIT-I
5. Affects It affects the sales and EBIT IT affects the EBIT and EPS.
6. Use/Fulcrum In operating leverage the In financial leverage the fulcrum
fulcrum is the fixed cost. is the fixed interest charges that
must be paid to service the long
term debt.
 [Link]

Combined Leverage:
When the company uses both financial and operating leverage to magnification of any change in
sales into a larger relative changes in earning per share. Combined leverage is also called as
composite leverage or total leverage. Combined leverage express the relationship between the
revenue in the account of sales and the taxable income.
Combined leverage can be calculated with the help of the following formulas:
CL = OL × FL

C OP C
CL = × =
OP PBT PBT
Where,
CL = Combined Leverage
OL = Operating Leverage
FL = Financial Leverage
C = Contribution
OP = Operating Profit (EBIT)
PBT= Profit before Tax
EBIT- EPS Analysis with different financing patterns
EBIT/EPS analysis allows managers to see how different capital structures affect the
earnings and risk levels of their firms. Specifically, it shows the graphical relationship between a
firm's operating earnings, (or) earnings before interest and taxes (EBIT) and its earnings per
share (EPS). Scenario analysis with different levels of EBIT can help analysts to see the effects
of different capital structures on the firm's earnings per share.
EBIT/EPS analysis is an older tool that was first developed when accounting concepts
dominated financial analysis. Also, most managers are familiar with the concept of earnings and
are more comfortable discussing the impact of leverage on earnings rather than on cash flow.
There is a close relationship between the financial leverage and Earning per Share of the
company. If degree of financial leverage is high and the return on investment is greater than the
cost of debt capital, then the impact of leverage on EPS will be favorable. The impact of
financial leverage is unfavorable when the earning capacity of the firm is less than what is
expected by the lenders (i.e.) the cost of debt.
Indifference Point/Level of EBIT
The level of earnings before interest and tax (EBIT) at which the earnings per share are
the same irrespective of the proportion of debt and equity is known as the point of indifference.
If the firm attains this particular level of earnings before interest and tax, the firm need not bother
about the debt-equity mix, since the earnings per share (EPS) will remain constant. Every
financial plan is equally desirable whether it suggests hundred percent debt or hundred percent
equity or 50-50 sharing between the two or, for that matter, any other proportion between debt
and equity. Through a formula, the indifference point can be explained thus:

(X-I1) (1-t)-Pd (X-I1) (1-t)-Pd

=

E1 E2
Where,
X = EBIT indifference or break-even point
I1 = Interest under alternative 1
I2 = Interest under alternative 2
t = Tax rate
 [Link]

pd = preference dividend
E1 = Number of equity shares (or amount of equity share capital) under alternative 1
E2 = Number of equity shares (or amount of equity share capital) under alternative 2