Page 182 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

3. Flexibility: Flexible capital structure means it should allow the existing capital structure Notes
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
firm.
The above stated are the general features of an appropriate capital structure. There may be
particular features for a firm, which may be additional. Further, the weight given to each of
these features will differ from firm to firm.

Self Assessment

State whether the following statements are true or false:

1. Company issues preference shares or redeemable debentures when it requires finance.
2. Trading on equity uses the variable cost sources of finance in capital structure of firm.
3. Optimum leverage is that mix of debt & equity which will maximise the market value of
the company.
4. Capital structure that allows the existing capital structure to change according to the
changing conditions without increasing the costs is called flexible capital structure.

5. EBIT-EPS Approach is helpful to analyse the impact of debt use on the shareholders value.

8.4 Computation of Optimal 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 1: In considering the most desirable capital structure of a company, a 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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