Definition

Capital Structure refers to the combination of debt and equity that a company uses to finance its operations and growth. The Capital Structure Decision involves determining the right mix of debt and equity to minimize the firm’s cost of capital and maximize shareholder value.

Major Considerations in Capital Structure Decision

• Cost of Capital: The goal is to minimize the Weighted Average Cost of Capital (WACC).
• Risk and Return: More debt increases financial risk but can also enhance return due to leverage.
• Control: Equity financing may dilute control of existing shareholders.
• Flexibility: The firm must have flexibility to raise capital when required.
• Market Conditions: Economic environment and investor sentiment influence the type of capital to raise.
• Cash Flow Position: Firms with stable cash flows can afford more debt.
• Legal and Regulatory Requirements: Compliance with laws, covenants, and credit terms.

Capital Structure Decision-Making Process

The following model describes the steps involved in making capital structure decisions:

Theories of Capital Structure

1. Net Income (NI) Approach

This theory suggests that increasing debt in the capital structure will decrease the overall cost of capital and increase the value of the firm because debt is cheaper than equity.

Example: A firm increases debt from 20% to 40%. Since interest is tax-deductible, overall cost reduces, increasing firm value.

2. Net Operating Income (NOI) Approach

According to this theory, capital structure is irrelevant. The cost of capital remains constant regardless of the debt-equity mix. The value of the firm is determined by its operating income and business risk.

Implication: Changing the capital structure will not affect firm value or WACC.

3. Traditional Approach

This theory combines elements of both NI and NOI approaches. It states that there is an optimal capital structure where the WACC is minimized and the firm value is maximized. Beyond this point, increasing debt increases financial risk and WACC rises.

Diagram (Example): U-shaped WACC curve against debt-equity ratio.

4. Modigliani and Miller (MM) Theorem

MM theory proposes that under perfect market conditions (no taxes, no transaction cost, perfect information), capital structure does not affect firm value.

• Without Tax: Capital structure is irrelevant.
• With Tax: The firm value increases with more debt because of the tax shield on interest.

Formula: Value of levered firm (VL) = Value of unlevered firm (VU) + (Tax Rate × Debt)

Example: If a firm has ₹10 lakh debt and tax rate is 30%, the value of the firm increases by ₹3 lakh due to tax benefit.

Conclusion

Capital Structure Decision is one of the most crucial aspects of financial management. An optimal capital structure minimizes the cost of capital, maximizes firm value, and balances risk and return. Managers must carefully evaluate both internal factors (like profitability and cash flows) and external factors (like market and interest rates) to determine the ideal capital mix.