Capital Structure Dilemma: Evaluation of Theories and Analysis of Royal Dutch Shell PLC and British Petroleum PLC

Executive Summary
The capital structure is known as debt amount and equity employed by the entity for
funding the processes and finances the assets. As per the technical point of view,
the capital structure is a cautious balance between equity and debt, which is used by
an organisation to finance the daily operations and its financial progress. The intent
of an evaluation of capital structure is to assess what mixture of equity and debt the
company is required to have. There are numerous conflicting capital structure
theories. These theories discuss the relations between financing through equity,
financing through debt and the market value of the company. In the following parts,
various theories of capital structure are discussed and critically examined.

CAPITAL STRUCTURE DILEMMA
Contents
Executive Summary.................................................................................................... 1
INTRODUCTION.........................................................................................................1
Aim and Objectives..................................................................................................1
SIGNIFICANT THEORIES of CAPITAL STRUCTURE AND UNDERLYING
RATIONALE................................................................................................................1
The conflicting argument against different capital structure theories.......................2
ANALYSIS OF THE CAPITAL STRUCTURES OF ROYAL DUTCH SHELL PLC AND
BRITISH PETROLEUM PLC.......................................................................................3
Royal Dutch Shell Plc..............................................................................................3
British Petroleum (BP) Plc.......................................................................................4
CONCLUSION............................................................................................................ 5
REFERENCE..............................................................................................................6

INTRODUCTION
The success of an organisation is the highly associated capital structure of the
company. It determines an appropriate combination of funds such as debt and equity. A
capital structure of an organisation is having a direct impact on risk, cost and revenue of the
company (Gornall and Strebulaev, 2018). For this purpose, the evaluation of the capital
structure of Royal Dutch Shell PLC and British Petroleum (BP) PLC is carried out. Therefore,
this report is going to evaluate different capital structure theories. In the context of the
present study, the aim and objectives of the present study are mentioned below:
Aim and Objectives
Aim
The aim of the present study is “To evaluate capital structure dilemma and its
importance in business operations”.
Objectives
As per the aim, some objectives are mentioned below:
 To examine different theories of capital structure
 To analysis conflict argument against capital structure theories
 To assess different aspects of assessing capital structure’s related changes.
SIGNIFICANT THEORIES of CAPITAL STRUCTURE AND UNDERLYING
RATIONALE
Capital structure theories play a critical role in determining an appropriate mix of
capital as per distinct business requirement. In this context, the four most important capital
structure theories are evaluated below:
 Net income approach: This approach plays a critical role in determining an
appropriate capital mix. According to this approach, a firm is able to minimise the
WACC by enhancing company’s value or prices of equity shares in the marketplace
and with the help of debt, which is an important source of funds (Ridley-Duff and Bull,
2015). The theory has defined that a company is able to increase its value as well as
decrease the whole cost of funds with enhancing a amount of loan financing in firm’s
capital structure (Ardalan, 2017).
 Net operating income approach: This approach has found very effective for
determining other great influence of leverage on firm’s value. This approach has
determined that alteration in the capital structure of a company is not having the
significant impact on company’s market value along with whole cost of capital (Mason
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and Harrison, 2017). This theory has determined that the cost of capital remains
constant whether an organisation has adopted the debt-equity mix.
 Conventional approach: The conventional approach is refered as the middle
approach between the both above discussed approaches. It is stated by the
conventional approach that the company’s market value may be enhanced or the cost
of capital may be decreased with considering more debt financing because it offers
funds ata very low price as compared to equity (Barclay and Smith, 2005). Therefore,
an organisationis able to get the best capital structure by considering the sound debt-
equity mix. However, some extent determines that the cost of equity increases as a
result of improved debt enhances monetary risks of company’s equity stakeholders
(Zhang, 2018). An increased cost of equity offsets benefit of cheap debt at this stage
of company’s capital structure. Therefore, it is not possible to manage the improved
cost of equity by an evaluation of advantages from the debt having lower-cost.
 Modigliani and Miller Approach (Mm Approach): Modigliani and Miller Approach is
an important theory of capital structure. The Modigliani and Miller Approach is
developed by the Franco Modigliani and Merton Miller (Graham and Harvey, 2001).
MM theory proposed two propositions for determining an appropriate mix of capital
structure:
o Proposition I: In this context, this approach determines that the determination of
company’s value, the capital structure is not so relevant. The value of two
identical firms would remain the same, and it does not have an important
influence on choice of various financial resources (Lemmon and Zender, 2019).
Therefore, the value of a firm is highly associated with the expected future
earnings if management does not consider any taxes.
o Proposition II: According to this approach, financial leverage plays a critical role
in influencing the value of a firm along with the reduction in WACC. This
proposition is consideredwhen tax-related information is available (Myers, 2001).
The conflicting argument against different capital structure theories
According to Net income operating approach and Net income approach, it has found
that COC would be reduced by increasing the raising the funds through debt because cost
debt is comparatively low to equity (Zhang, 2018). On the contrary to assumptions of two
theories of capital structure, it has addressed that the increased use of debt will be
enhanced the financial risk of the equity shareholders that would result in an overall cost of
equity (Serfling, 2016). Therefore, it can be stated that capital structure theories are not
appropriate because these approaches have determined that the cost of debt remains
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