CAPITAL STRUCTURE
Capital Structure means a combination of all long-term sources of finance.It includes equity share capital,loans,debentures and other such long-term sources of finance.
Capital Structure is the combination of debts and equity securities that comprises a firm's financing of its assets.
The term capital structure is frequently used to indicate the long-term sources of fund employed in a business enterprises.
FACTORS OF CAPITAL STRUCTURE
1 - INTERNAL FACTORS
a)- NATURE OF BUSINESS - Every business concern has its own capital structure.Large manufacturing industries need heavy fixed assets therefore these industries collect their finance through issue of debentures and raising of long-term debts.
b)- NATURE OF INCOME - Capital Structure is also affected by regularity and certainty of income.Debentures may be issued or long-term debts may be raised if there is a certainty or regularity of income.
c)- DESIRE TO CONTROL BUSINESS - If the promoters and founders of a company want to control the business then equity shares are issued and large number of these shares is held by a group of some people who want to control the business.
d)- POLICIES OF MANAGEMENT - The nature of capital structure also depends on the financial policies of management.
2 - EXTERNAL FACTORS
a)- COST OF CAPITAL - Cost of capital should also be kept in mind while determining the capital structure of a business.Capital Structure should be of such type which creates minimum average cost of capital of different sources.
b)- CHOICE OF INVESTORS - Nature and type of investors should also be considered at the time of framing capital structure.
c)- CONDITIONS OF CAPITAL MARKET - Capital Market condition have significant influence over capital structure.During depression period interest rates fall and profit earning capacity become uncertain and irregular,so in such conditions debentures are more popular.
d)- RULES AND REGULATIONS - Rules and Regulations also affect the nature of capital structure.Under income tax rules dividend paid on shares is not considered as business expenditure,while interest paid on debentures is considered as business expenditures.
THEORIES OF CAPITAL STRUCTURE
1 - NET INCOME APPROACH -
This approach being propounded by Durand State that there is a relationship between the value of the company and its cost of capital,i.e.,the value of company is dependent on the capital structure of the company.The change in capital structure via cost of capital results into change in the value of company.
According to this approach,the increase in the proportion of debt in the capital structure of the company brings decrease in the overall cost of capital because debt is a cheapest source of finance.
2 - NET OPERATING INCOME APPROACH -
This approach is entirely opposite to the net income approach and this approach was also given by Durand.This approach suggests that there is no relationship between capital structure and value of the company.In other words,the value of the company is independent of capital structure of the company.
3 - MODIGLIANI-MILLER APPROACH -
It recognize the irrelevance of the capital structure and thus is akin to net operating income approach.It supports the net operating income approach relating to the independence of cost of capital and the degree of leverage.However,the methodology used by the MM approach significantly differ from net operating income approach .
MM approach used arbitrage method to justify the crux of its argument.MM approach maintain that the weighted average cost of capital remains constant even with a change in the proportion of debt to equity in the capital structure.
4 - TRADITIONAL APPROACH -
This approach takes an intermediate view between net income approach and net operating income approach.As such the increase in debt capital in capital structure does causes a decrease in overall cost of capital and thus the value of company increases.The shareholders are also indifferent to risk perception.But after a certain stage if further debt capital is added to the capital structure,the risk perception of the shareholder changes.
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