28-06-2012, 04:33 PM
Capitalisation , Capital Structure and Financial Structure
Capitalisation.ppt (Size: 134 KB / Downloads: 44)
Capitalisation refers to the total amount of securities issued by a company while capital structure refers
to the kinds of securities and the proportionate amounts that make up capitalisation. For raising long-
term finances, a company can issue three types of securities viz, Equity shares, Preference shares
and Debentures. A decision about the proportion among these type of securities refers to the capital
structure of an enterprise.
Financial structure refers to all the financial resources used by the firm, short as well as long-term, and
all forms of debt as well as equity.
Forms/ Patterns of Capital Structure:
1 Equity Shares only
Equity and Preference Shares
Equity Shares and Debentures
Equity Shares, Preference Shares and Debentures.
Importance of Capital Structure:
The term capital structure refers to the relationship between the various long-term forms of
Financing such as debenture, preference share capital and equity share capital. Financing
the firm’s assets is a very crucial problem in every business and as a general rule there should
be proper mix of debt and equity capital in financing the firm’s assets. The use of long-term
fixed interest bearing debt and preference share capital along with equity shares is called
financial leverage or trading on equity. The long-term fixed interest bearing debt is employed
by a firm to earn more from the use of these sources than their cost so as to increase the
return on owner’s equity. It is true that capital structure cannot affect the total earnings of the firm but
it can increase earning available for equity shareholders.
Optimal Capital Structure:
The optimum capital structure may be defined as “ that capital structure or combination of debt
and equity that leads to the maximum value of the firm.” Optimal capital structure maximises the
value of the company and hence the wealth of its owners and minimises the company’s cost
of capital’. Thus, every firm should aim at achieving the optimal capital structure and then to maintain it.
Theories of Capital Structure:
Different kinds of theories have been propounded by different authors to explain the
relationship between capital structure, cost of capital and value of the firm. The main
Contributors to the theories are Durand, Ezra, Solomon, Modigliani and Miller.
Net Income Approach
Net Operating Income Approach
The Traditional Approach
Modigliani and Miller Approach
Net Income Appoach: According to this approach, a firm can minimise the weight average
cost of capital and increase the value of the firm as well as market price of equity shares by
using debt financing to the maximum possible extent. The theory propounds that a company
can increase its value and reduce the overall cost of capital by increasing the proportion
of debt in its capital structure. This approach is based upon the following assumptions:
The cost of debt is less than the cost of equity.
There are no taxes.
The risk perception of investors is not changed by the use of debt.
The line of argument in favour of net income approach is that as the proportion of debt
Financing in the capital structure increase, the proportion of a less expensive source of funds