Capital Structure – Introduction

What Is Capital Structure?

Capital structure is the composition of long-term funds that a company uses to finance its assets and operations. Think of it as the financial skeleton of the organization—it describes how much of the company is financed through debt and how much through equity.

More precisely, capital structure comprises the proportions of equity share capital, preference share capital, debentures, long-term loans, retained earnings, and other long-term sources of funds. Notice that I said long-term sources. This distinction is crucial because many students confuse capital structure with financial structure, and the exam often tests this difference.

Here's the critical distinction: financial structure includes everything on the left side of a company's balance sheet—both short-term liabilities (like accounts payable and short-term borrowings) and long-term liabilities plus equity. Capital structure, however, includes only the long-term components. Short-term debt doesn't appear in capital structure calculations because it's temporary in nature and doesn't represent the permanent funding arrangement of the firm.

Components of Capital Structure

To work effectively with capital structure problems, you need to know exactly what gets included. Let me break down each component:

a. Equity Share Capital

This represents the ownership stake in the company. Equity shareholders are the true owners, bearing the highest risk but also having claim to residual profits. When a company issues equity shares, it's essentially selling ownership pieces. These shares can be issued at par value, at a premium, or at a discount, but regardless of the issue price, they form a permanent part of the capital structure.

b. Preference Share Capital

Preference shares occupy an interesting middle ground. Preference shareholders receive a fixed dividend before equity shareholders receive anything, giving them preference in distribution. However, they typically don't have voting rights. From a capital structure perspective, preference shares are considered part of equity, though they carry characteristics that make them somewhat hybrid in nature—they're less risky than equity but more risky than debt.

c. Retained Earnings

This is profit that the company has earned but hasn't distributed to shareholders. It's internally generated capital, and it's crucial to understand that retained earnings don't require any external financing cost. When a company uses retained earnings to fund operations or investments, it's using funds that already belong to shareholders. This makes retained earnings one of the cheapest sources of capital available to a firm.

d. Debentures and Long-Term Debt

These are borrowed funds with fixed repayment obligations. Debentures are unsecured long-term debt instruments, while other long-term loans might be secured against specific assets. The critical feature is that debt carries a fixed interest obligation, making it cheaper than equity on a pre-tax basis (because interest is tax-deductible), but it also increases financial risk because the company must pay interest regardless of profitability.

e. Other Long-Term Sources

This category includes convertible debentures, quasi-equity instruments, and institutional loans. Convertible debentures are particularly interesting because they start as debt but can be converted into equity under certain conditions, giving them hybrid characteristics.

Now, what's *not* included? Short-term creditors, accounts payable, and current liabilities stay out of capital structure. They're part of financial structure but not capital structure. Also, fixed assets themselves aren't part of capital structure—capital structure describes how you finance assets, not the assets themselves. That's the domain of asset structure.

The Importance of Capital Structure Decisions

Why should you care deeply about capital structure? Because it directly impacts three things that matter enormously to any business: the cost of capital, the firm's value, and financial risk.

a. Impact on Cost of Capital

Every source of capital carries a cost. Equity capital requires a return to compensate shareholders for their risk. Debt capital requires interest payments. Retained earnings, while not explicitly costing cash, represent an opportunity cost—that money could have been distributed to shareholders for them to invest elsewhere. The weighted average cost of capital (WACC) combines all these costs, weighted by their proportion in the capital structure. Change the capital structure, and you change the WACC. This matters because the WACC becomes the discount rate for evaluating investment projects. A lower WACC means more projects become viable, potentially creating more value for the firm.

b. Impact on Firm Value

Here's where it gets interesting. The fundamental question that capital structure theories grapple with is: does the proportion of debt versus equity affect the total value of the firm? You might think it shouldn't—after all, whether you cut a pie into two pieces or four pieces, it's still the same pie. But corporate finance isn't quite that simple. The answer depends on taxes, financial risk, and market imperfections—which is precisely why different theories offer different perspectives.

c. Impact on Financial Risk and Returns

Increasing debt increases financial leverage, which amplifies returns to equity shareholders when times are good, but it also amplifies losses when times are bad. This is financial risk—the risk that arises from using debt financing. It's distinct from business risk, which comes from the uncertainty of the company's operating environment. A company in a stable industry might take on more debt safely; a company in a volatile industry should be more cautious.

Business Risk Versus Financial Risk

This distinction is fundamental, and I've seen many students blur these concepts. Let me clarify:

Business risk is the uncertainty in a company's operating income due to factors like competition, market demand, technological change, and economic cycles. It exists regardless of how the company finances itself. A software company in a rapidly changing market faces high business risk; a regulated utility faces low business risk. Business risk is determined by the company's industry and strategic position, not by its capital structure.

Financial risk is the additional uncertainty in equity returns caused by the use of debt financing. When a company borrows money, it commits to fixed interest payments. If operating income falls, the company still must pay that interest, leaving less (or nothing) for equity shareholders. Financial risk is a choice—it's determined by the capital structure decision. A company can have high business risk but low financial risk if it uses mostly equity financing, or it can have low business risk but high financial risk if it uses substantial debt despite operating in a stable industry.

The relationship is additive: total risk to equity shareholders equals business risk plus financial risk. This is why you'll see financial risk increase with leverage—each additional unit of debt magnifies the impact of business risk on equity returns.

Capital Structure Theories

Now we arrive at the theoretical frameworks that explain how capital structure affects firm value and cost of capital. Different theories make different assumptions about market conditions and investor behavior, leading to different conclusions. Understanding these theories and their assumptions is essential for the exam and for real-world financial decision-making.

a. The Net Income (NI) Approach

The NI approach, suggested by Durand, is perhaps the most optimistic theory regarding the benefits of debt. It argues that the value of the firm can be increased by increasing the proportion of debt in the capital structure.

Here's the logic: debt is cheaper than equity. Why? Because interest payments are fixed and predictable, making debt less risky from the lender's perspective. Equity shareholders, bearing the residual risk, demand higher returns. Therefore, if a company increases debt and decreases equity, it can lower its weighted average cost of capital, which increases firm value.

Under the NI approach, there exists an optimal capital structure—a debt-to-equity mix that minimizes the cost of capital and maximizes firm value. The approach assumes that the cost of debt (Kd) and cost of equity (Ke) remain constant as leverage increases. This is a critical assumption, and it's precisely where the NI approach faces criticism.

Example: Imagine a company with annual operating income of ₹100 lakhs. Under NI approach assumptions:

Notice how firm value increases with debt? That's the NI approach in action. The savings from cheaper debt financing exceed the reduction in equity value, creating a net gain.

b. The Net Operating Income (NOI) Approach

If the NI approach is optimistic about debt, the NOI approach is its opposite—it's pessimistic. The NOI approach, also suggested by Durand, argues that capital structure is *irrelevant* to firm value. No matter how you mix debt and equity, the total value of the firm remains unchanged.

The logic here is that as financial leverage increases, the cost of equity rises to offset the advantage of cheaper debt. The market capitalizes the firm's operating income as a whole at a constant overall cost of capital (Ko). As debt increases, debt holders become worried about their security, so they demand higher interest rates. Simultaneously, equity shareholders, seeing increased financial risk, demand higher returns. These two effects perfectly offset each other, leaving the weighted average cost of capital unchanged.

Under NOI assumptions, the overall cost of capital Ko remains constant regardless of capital structure. This means there's no optimal capital structure—every capital structure is equally optimal (or equally mediocre, depending on your perspective).

Example using the same company:

See the difference? Under NOI, firm value stays at ₹833.33 lakhs regardless of capital structure. The value of equity decreases as debt increases, but that's because shareholders' claim is reduced—the pie isn't growing, it's just being divided differently.

c. The Traditional Approach

The traditional approach represents a middle ground between NI and NOI. It argues that there *is* an optimal capital structure, but it's not at the extreme of all equity or all debt. Instead, there's a range of leverage where the cost of capital decreases, and beyond that range, it increases.

The traditional approach suggests that in the initial stages of increasing leverage, the cost of equity doesn't increase proportionally to the cost of debt. This means WACC decreases. However, beyond a certain point, equity holders become concerned about financial risk and demand significantly higher returns. At this point, the rising cost of equity outweighs the benefit of cheaper debt, and WACC starts rising. This creates an optimal capital structure somewhere in the middle.

The traditional approach makes intuitive sense and aligns with how many practitioners think about capital structure. It recognizes that some debt is good (it's cheaper and provides tax benefits), but too much debt becomes dangerous (increasing the risk of financial distress).

d. The Modigliani-Miller (MM) Approach

Modigliani and Miller, two Nobel Prize-winning economists, provided a rigorous theoretical framework that initially supported the NOI approach but later incorporated taxes, fundamentally changing the analysis.

MM Proposition I (without taxes): In a world without taxes and transaction costs, the value of a firm is independent of its capital structure. This is essentially the NOI approach with mathematical rigor. MM argued that if two identical firms differ only in their capital structure, arbitrage opportunities would force their values to be equal. An investor could replicate the leverage of any firm by personally borrowing or lending, making the firm's capital structure irrelevant.

MM Proposition II (without taxes): The cost of equity increases linearly with financial leverage. As a firm takes on more debt, equity becomes riskier, and shareholders demand higher returns. The formula is:

Ke = Ko + (Ko - Kd) × (D/E)

Where Ke is cost of equity, Ko is the overall cost of capital, Kd is cost of debt, and D/E is the debt-to-equity ratio. This shows that as debt increases, the cost of equity rises to exactly offset the benefit of cheaper debt.

MM Proposition I (with taxes): This is where MM's analysis becomes crucial for real-world finance. With corporate income taxes, debt becomes advantageous because interest payments are tax-deductible, but dividend payments to equity holders are not. This creates a tax shield—the tax savings from deducting interest. Therefore, in a world with taxes, firm value *does* increase with debt, up to the point where financial distress costs become significant.

The value of the firm with debt equals the value of the firm without debt plus the present value of the tax shield from debt:

V(L) = V(U) + Tc × D

Where V(L) is the value of the levered firm, V(U) is the value of the unlevered firm, Tc is the corporate tax rate, and D is the value of debt. This suggests that to maximize firm value, a company should use as much debt as possible—a conclusion that seems extreme but is theoretically sound until you account for bankruptcy costs and financial distress.

Example with taxes: If our company has a 30% tax rate and can borrow at 10%, the annual tax shield from ₹50 lakhs debt is:

Tax Shield = 0.30 × 0.10 × ₹50 lakhs = ₹1.5 lakhs per year

If this is perpetual debt, the present value of the tax shield is:

PV of Tax Shield = ₹1.5 lakhs / 0.10 = ₹15 lakhs

This ₹15 lakhs is pure value created by using debt instead of equity, purely due to the tax deductibility of interest.

Practical Implications and Decision Framework

So which theory is correct? The honest answer is that they're all partially correct—they operate under different assumptions and highlight different aspects of reality.

In practice, companies should consider multiple factors when determining capital structure:

a. The Cost Principle

The optimal capital structure is the debt-equity mix at which the cost of capital is lowest and the market value of the firm is highest. This principle draws from multiple theories and suggests that you should calculate WACC at different leverage levels and choose the structure that minimizes it.

b. The Risk Principle

Higher debt means higher financial risk. Debt requires fixed payment obligations regardless of profitability. A company should not increase leverage beyond the point where financial distress becomes a realistic concern. The appropriate level of debt depends on the stability and predictability of the company's cash flows. A utility company with stable, predictable cash flows can safely use more debt than a technology startup with volatile revenues.

c. The Pecking Order Theory

This theory, developed by Donaldson and later formalized by Myers and Majluf, suggests that companies follow a hierarchy when raising capital. They prefer internally generated funds (retained earnings) first, then debt, and finally equity as a last resort. Why? Because each financing method sends a signal to the market. If a company issues new equity, it might signal that management thinks the stock is overvalued. This theory explains why many companies maintain lower debt levels than theories like MM would suggest—they want to preserve financial flexibility and avoid the negative signals of equity issuance.

Factors Influencing Capital Structure Decisions

Beyond the theories, several practical factors influence how companies actually structure their capital:

a. Industry Characteristics

Capital-intensive industries like utilities, telecommunications, and infrastructure typically use higher leverage because their stable, predictable cash flows can support debt service. Technology and retail companies, facing more volatile earnings, typically use less leverage.

b. Company Size and Credit Rating

Larger, well-established companies with strong credit ratings can borrow at lower rates and can therefore support higher leverage. Smaller companies and startups face higher borrowing costs and less access to debt markets, limiting their ability to use leverage.

c. Asset Structure

Companies with tangible, liquid assets (real estate, equipment) can use more debt because these assets serve as collateral. Companies with intangible assets (intellectual property, brand value) face difficulty in using these assets as collateral, limiting their debt capacity.

d. Profitability and Growth

Highly profitable companies often use retained earnings for financing, reducing their need for external capital. High-growth companies needing substantial capital might use more debt if they can service it from expected future cash flows.

e. Tax Considerations

The tax deductibility of interest makes debt more attractive to companies in high tax brackets. Companies with substantial tax losses or tax credits have less benefit from debt's tax shield and might use less leverage.

Common Exam Questions and Solutions

Let me walk you through how to approach typical exam questions on capital structure:

a. Identifying Components of Capital Structure

Question: Which of the following forms of capital structure consists of zero debt components in the structure mix?

Analysis: Zero debt means the company is financed entirely through equity. This would include only equity shares, preference shares, and retained earnings—no debentures, no long-term loans, no bonds.

Answer: An all-equity capital structure.

b. Comparing Theories

Question: According to the Net Income approach, what happens to firm value as debt increases?

Analysis: The NI approach assumes that cost of debt and cost of equity remain constant as leverage increases. Since debt is cheaper than equity, increasing the proportion of debt decreases WACC, which increases firm value (since V = EBIT / WACC).

Answer: Firm value increases as debt increases (until reaching the optimal structure).

c. Calculating WACC Under Different Structures

Question: A company has the following information:

• EBIT = ₹100 lakhs
• Cost of Equity = 15%
• Cost of Debt = 8%
• Tax Rate = 30%
• Debt = ₹200 lakhs, Equity = ₹300 lakhs

Calculate WACC.

Solution:

Total Value = ₹200 + ₹300 = ₹500 lakhs

Weight of Debt = 200/500 = 0.40

Weight of Equity = 300/500 = 0.60

After-tax Cost of Debt = 8% × (1 - 0.30) = 8% × 0.70 = 5.6%

WACC = (0.40 × 5.6%) + (0.60 × 15%) = 2.24% + 9% = 11.24%

Conclusion: Bringing It All Together

Capital structure isn't about following a single formula or theory—it's about making informed decisions within your company's specific context. The theories provide frameworks for thinking about trade-offs. The NI approach reminds us that debt can be cheaper and create value through tax shields. The NOI approach cautions us that increasing leverage increases risk proportionally. The traditional approach acknowledges that there's likely an optimal range. MM's work shows us the power of taxes in the capital structure equation.

In corporate finance, you'll find that companies use elements of all these approaches. They calculate WACC at different leverage levels (practical application of traditional approach), they consider tax shields (MM with taxes), they maintain financial flexibility (pecking order theory), and they respect industry norms (practical risk management).