Page 131 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 7: Capital Structure Decision

years, then it will be appropriate to raise borrowed funds. However, if the funds are Notes
required more or less permanently, it will be appropriate to raise them by the issue of
equity share.
15. Nature of Enterprise: The nature of enterprise too, to a great extent, affects the capital
structure or the company. Business enterprises that have stability in their earnings or
those who monopoly regarding their products may go for borrowings or preference
shares, since they have adequate profits to pay interest/fixed charges. On the contrary,
companies, which do not have assured income, should preferably rely on internal resources
to a large extent.
16. Requirement of Investors: Different types of securities are issued to different classes of
investors according to their requirement.
17. Provision for Future: While planning capital structure the provision for future requirement
of capital is also to be considered.

!
Caution Along with the risk as a factor, the finance manager has to consider the cost aspect
carefully while determining the capital structure.

Self Assessment
Fill in the blanks:
4. In the context of capital structure planning, ……………..risk is relevant.
5. Along with cost and risk factors, the …………..aspect is also important consideration in
planning the capital structure.
6. In case a firm has higher debt content in capital structure, the risk of variations in
…………………….available to equity shareholders will be higher.

7.3 Value of the Firm and Capital Structure
Value of the firm depends on the earnings of the firm and earnings of the firm depend upon the
investment decisions of the firm.
Investment decision influences the size of the EBIT. The EBIT is shared among three main
claimants:
1. The debt holders who receive their share in the form of interest.
2. The government which receives its share in the form of taxes.
3. The shareholders who receive the balance.

Thus, the investment decisions of the firm determine the size of the EBIT pool while the capital
structure mix determines the way it is to be sliced. The total value of the firm is the sum of the
value to the debt holders and its shareholders. Therefore, investment decision can increase the
value of the firm by increasing the size of the EBIT whereas capital structure mix can affect the
value only by reducing the share of the EBIT going to the government in the form of taxes.
Thus, the value of the firm, investment decisions and capital structure decisions are closely
related and is depicted by the following figure.

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