Page 108 - DMGT409Basic Financial Management

Unit 6: Capital Structure Theory

An appropriate capital structure should have the following features: Notes
1. Profitability/Return: As we have seen in the above discussion the appropriate capital
structure is one, which is most advantageous. With the constraints, maximum use of
leverage at a minimum cost should be made. In other words, it should generate maximum
returns to the owners without adding additional cost.
2. Solvency/Risk: The use of more or excessive debt threatens the solvency of the firm. Debt
should be used till the point where, debt does not add significant risk, otherwise use of
debt should be avoided.
3. Flexibility: Flexible capital structure means it should allow the existing capital structure
to change according to the changing conditions without increasing cost. It should also be
possible for the firm to provide funds whenever needed to finance its possible activities.
The Firm should also repay the funds if not required.
4. Conservation/Capacity: Capital should be conservative in the sense that the debt capacity
of a firm should not be exceeded. In other words, the capital structure should be determined
within the debt capacity of the firm and not beyond the firm’s capacity. The debt capacity
of a firm depends on its ability to generate future cash inflows. It should have enough cash
to pay its fixed charges and principal sum.
5. Control: Use of more equity may lead to loose my control of the company. The competitors
from (closely held firms) are particularly concerned about the dilution of control. Hence,

construction of capital structure should not involve the risk of loss of control over the
fi rm.

6.6.1 Computation of Optimum Capital Structure

As we already know that optimum capital structure is that capital structure at debt equity

proportion where the market value per share and value of the firm is maximum or the overall
cost of capital is minimum. But here, since, calculation of market value of share or value of the

firm is beyond the scope of this book. Hence, capital structure is calculated based on overall cost
of capital.
Illustration 5: In considering the most desirable capital structure of a company. Financial
manager has estimated the following.
Debt as a % of total Capital Employed Cost of Equity (%) Cost of Debt (%)
0 10.0 6.0
10 10.0 6.0
20 10.5 6.0
30 11.0 6.5
40 12.0 7.0
You are required to determine the optimal debt - equity mix or optimal capital structure by the
calculation of overall cost of capital.

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