Mostly Asked Capital Structure Interview Preparation Guide

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Miller’s hypothesis with corporate and personal taxes : This approach gives important advantage over equity. This ignores bankruptcy and agency costs.

Trade-off theory: costs and benefits of leverage.

MM hypothesis with and without corporate tax : This approach tells that firm's value is independent of capital structure. The same return can be received by shareholders with the same risk.

Traditional approach and Net income (NI) approach :- this is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and don’t depend on how much debt the firm is using.

Net operating income (NOI):- this is an approach in which both value of the firm and weighted average cost are independent of capital structure. Individual holding the debt and equity receives the same cash flows without worrying about the taxes as they are not involved in it.

it is a leverage which refers to high profits due to fixed costs. It includes fixed operating expenses with fixed financial expenses. It indicates leverage benefits and risks which are in fixed quantity. Competitive firms choose high level of degree of combined leverage whereas cooperative firms choose lower level of degree of combined leverage.

it is a leverage which refers to high profits due to fixed costs. It includes fixed operating expenses with fixed financial expenses. It indicates leverage benefits and risks which are in fixed quantity. Competitive firms choose high level of degree of combined leverage whereas cooperative firms choose lower level of degree of combined leverage.

It is a leverage which refers to high level of profitability because of high fixed financial expenses. It includes interest on loan and preference dividend. Higher financial leverage indicates higher financial risk as well as higher break points. In this kind the managers have flexibility in choice of capital structure.

it is a leverage which refers to the enhancement of profits because there is a fixed operating cost which is involved with each and every component. When the sales increases fixed cost doesn't increase and it results in higher profits. Higher fixed expenses results in higher operating leverage which leads to higher business risk.

Timing Principle: this principle deals with capital structure which should be able to have market opportunities and which should be able to minimize cost of raising funds and obtain the savings.

Flexibility Principle: this principle deals with capital structure which can have additional requirements of funds in future.

Control Principle: this principle deals with the capital structure which is keeping the controlling position of owners. Preference shareholders possesses no voting rights and don't disturb positions.

Risk Principle: this principle deals with the capital structure which should not accept high risk. If company issue large amount of preference shares out of the earnings of the company then less amount will be left out for equity shareholders as dividend is paid after the preference shares.

Cost Principle: this principle deals with the ideal capital structure which should minimize cost of financing and maximize the earnings per share. The cheaper form of capital structure is debt capital.

These factors have been considered by the private companies while raising additional funds and planning the capital structure. In this company plans to raise long term funds by issue the equity and preference shares. It doesn't have relation with the borrowed capital.

Company raising the capital by borrowed capital, as it accepts the risk in two ways:

(i) Company maintains the payment of interest as well as installments of borrowed capital at predecided rate and time without being concerned about the profits and losses.

(ii) Borrowed capital is secured capital in the case where the company fails to meet the contract done with the lenders of the money.

it is a process of raising the funds which involves the cost in planning the capital structure, the use of capital should be capable of earning revenue to meet the cost of capital. There are changes in this because of two reasons:

(i) Interest rates are less than dividend rates.

(ii) Interest paid on borrowed capital is an allowable for income tax purposes.

The internal factors which are affecting capital structure are as follows:-

1) Cost of capital : - it is a process of raising the funds which involves the cost in planning the capital structure, the use of capital should be capable of earning revenue to meet the cost of capital. There are changes in this because of two reasons:

(i) Interest rates are less than dividend rates.

(ii) Interest paid on borrowed capital is an allowable for income tax purposes.

2) Risk factor : Company raising the capital by borrowed capital, as it accepts the risk in two ways:

(i) Company maintains the payment of interest as well as installments of borrowed capital at predecided rate and time without being concerned about the profits and losses.

(ii) Borrowed capital is secured capital in the case where the company fails to meet the contract done with the lenders of the money.

3) Control Factor: These factors have been considered by the private companies while raising additional funds and planning the capital structure. In this company plans to raise long term funds by issue the equity and preference shares. It doesn't have relation with the borrowed capital.

The external factors which are affecting the capital structure are as follows:-
1) Economic Conditions: If the economy is in state of depression, preference is given to equity form of capital which involves less amount of risk but it is avoided in some cases where the investor is not ready to take the risk. In this case company go on with the borrowed capital.

2) Interest Rates level : Form of borrowed capital will be delayed if the funds are available in high rates of interest but raising is not favourable.

3) Lending Policy : If policy is hard to understand and not flexible then it is good to go with the borrowed capital.

4) Taxation Policy: This policy should be viewed from both the sides from individual as well as corporate perspective. From the individual point of view both interest as well as dividend will be taxable in hands of lender.

The general factors which are affecting the capital structure are as follows:-

1) Company constitution : In companies capital structure is very important as many companies treat it as a different entity. Private companies considers control factor as important whereas public company finds cost factor more important.

2) Company characteristics : Characteristic of the company which describe its infrastructure as size, age and credit plays pivotal role in deciding the capital structure. Smaller or newly started companies depend more on equity capital as they can do limited bargaining. Large companies or having good credit companies are in the position to get funds from the source of their choice.

3) Stability of Earnings : Fluctuations occurs if the sales and earnings of the company are not stable enough over a period of time. Stable company can take the risk.

4) Attitude of the Management: Attitude plays an important role as if the attitude is conservative then control factor gets the importance and if it is liberal then cost factor gets important.

The component cost is the one which comes under the cost of capital and it has three levels:-

(i) Return at zero risk level: which tells about the expected rate of return when there is no risk involved in the project

(ii) Premium for business risk: This tells about the variance in operating profit due to change in sales.

(iii) Premium for financial risk: This tells about the captital structure risk.

It is the decision whether to buy components or services from an outsider or not. It requires understanding the cost associated with building and buying the components.

Composite Capital is also called the weighted average of component cost of common stock, preference shares and debt. In this each of the components is given an importance on its interest rate, risk analysis and management loss of control which is used to compute the composite capital.

Average cost is also called as unit cost which is equal to the total cost divided by number of goods produced or also equal to the sum of average variable costs and the average fixed costs. This depends on the time period and also has the affect on the supply curve.

Marginal cost is the change in total cost which takes place when there is a change in quantity by one unit. It depends on the change in volume. It includes at each level of the production additional costs which is required to produce the next unit. For example building a building requires building the base then you require extra cost for space and other building material.

Explicit cost is the cost which is external to the business like wage, rent and materials. It gives clear picture of the cash outflow from business which is used to decrease the end result of profitability. This directly affects the revenue of the company.

Implicit cost is the result of one person who tries to satisfy his needs in search of an activity which gives no reward to him by money or another form of payment. It includes benefits and satisfaction. For example- goodwill. It is not counted in terms of money and it is indirect intangible cost.

Cost of the capital is the rate of return which is minimum which has to be earned on investments in order to satisfy the investors of various types who are making investments in the company in the form of shares, debentures and loans. It is used in financial investment which refers to the cost of a company's funds or the shareholders return on the company's existing deals. It is the required rate that a company must achieve to cover the cost of generating funds in the market. By seeing this only the investor invests the money in the company if the company is giving the required rate of return. It is a guideline to measure the profitability of different investments.

The importance of cost of capital is that it is used to evaluate new project of company and allows the calculations to be easy so that it has minimum return that investor expect for providing investment to the company. It has such an importance in financial decision making. It actually used in managerial decision making in certain field such as-

1) Decision on capital budgeting- It is used to measure the investment proposal to choose a project which satisfies return on investment.

2) Used in designing corporate financial structure- it is used to design the market fluctuations and try to achieve the economical capital structure for firm.

3) Top management performance- It evaluates the financial performance of top executives. It involves the comparison of actual profit of the projects and taken projects overall cost.

Cost of capital is measured in terms of weighted average cost of capital. In this the total capital value of a firm without any outstanding warrants and the cost of its debt are included together to calculate the cost of capital.

To calculate the company's weighted cost of capital, first the calculation of the costs of the individual financing sources:

Cost of Debt Cost of Preference Capital, Cost of Equity Capital, and cost of stock capital take place and the formula is given as:-

WACC= Wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. Stock)

where WACC= weighted average cost of capital