Examining Optimal Capital Structure and Relevance of Dividends

This report provides an in-depth analysis of financial management essentials, focusing on the feasibility of an optimal capital structure and the relevance of dividend policy. It explores the optimal capital structure as a balance between debt and equity, aiming to maximize wealth and minimize capital costs, while also discussing its determinants, features, and related theories like the Net Income (NI), Traditional, Net Operating Income (NOI), and Modigliani-Miller (MM) approaches. The report also assesses dividend policies, emphasizing their importance to investors and firms, and delves into relevance theories such as Gordon's model and Walter's approach. The feasibility analysis of an optimal structure is explained as a tool to evaluate the practicality of a business project and examine available alternatives. The study concludes by underscoring the significance of informed decision-making in financial management, considering future aspects and the impact of dividend policies on organizational assessment and evaluation.

FINANCIAL
MANAGEMENT
ESSENTIALS

Table of Contents
INTRODUCTION ..........................................................................................................................3
TASK...............................................................................................................................................3
Identify, evaluate and examine the related arguments for and against the feasibility of an
optimal capital structure and Analyse the relevance of a dividend policy..................................3
CONCLUSION ...............................................................................................................................8
REFERENCES................................................................................................................................9

INTRODUCTION
The report prepared above explains the idea of financial management and how it can be
managed for carrying out accounting practices as well (Abd Karim, Nawawi and Salin, 2018) . It
explains the usage of accounting tools and techniques that would help to prepare & develop
financial records/ statements that would reflect a positive overview of company's related
activities & financial position as well. It takes in account explanation of optimal capital structure
as well that explains the appropriate mixture of equity financing and debts that increases market
value of business while reducing its cost of capital. It is necessary as it contribute in raising net
worth and futuristic cash flows of a company. It also takes in account relation of dividend
policies i.e. dividends that are paid by enterprises are seen positively by firms and investors as
well. It also contributes in assessment and evaluation of a organisation. The report further would
help to provide related guidance for efficient & effective decision making keeping future aspects
in mind. It explains various models and theories that give a clear picture of its relevance in a
dividend policy. These are Gordon's model, Walter approach, Dividend signalling etc.
TASK
Identify, evaluate and examine the related arguments for and against the feasibility of an optimal
capital structure and Analyse the relevance of a dividend policy.
Optimal capital structure of a company can be explained as a magnitude in which it
builds a structure of debt and equity. It is developed for maintaining adequate balance among
worth of a business and for maximisation of wealth which in return helps to minimize risk and
expenses related to capital areas. Equity reflects more costly and expensive as well as long term
source of capital with comparatively higher level of financial flexibility. The important
determinants of optimum capital structure can be defined such as sales and growth, cash flow,
risk involved, cost of capital and flexibility as well (Arnold and Lewis, 2019).
There are certain features involved in Optimum capital structure such as Solvency,
flexibility, profitability, simplicity, controlling and value maximisation of a company. It is useful
because in case of sound and efficient capital structure, content of debt would be a sensible
proportion of capital employed in the organisations. As a consequence, it has lesser risk involved
in becoming bankrupt. Flexibility in such context can be explained as a time when the firm is
capable of raising & generating funds as and when required. An optimum structure consisting of

capital can be defined such as that helps to maximise earning per equity share and cutting down
cost related to financial areas. It is well known that not all business persons are well educated
and less people have a thorough knowledge about related complex activities involved in such
structures. It thus demands a good and specialised knowledge to understand such key terms &
their working as well. Thus, it is advised that a capital structure must be easy and in a simple
form to be understood by everyone. Capital structure must be designed and developed in such a
way that it must include reduced risk and control the losses which are prevailing. It helps to add
value to the enterprise and increase the profitability as well (Baporikar and Akino, 2020).
Capital structure is the combination of capitals from different sources of finance. The
capital of a company consists of equity share holders’ fund, preference share capital and long
term external debts. The source and quantum of capital is decided keeping in mind the following
factors:
Control: Capital structure should be designed in such a manner that existing shareholders
continue to hold majority stake.
Risk: Capital structure should be designed in such a manner that financial risk of a company
does not increase beyond tolerable limit.
Cost: Overall cost of capital remains minimum.
The following are the related arguments or theories which are helpful in deciding the optimal
capital structure for the business: -
 Net Income (NI) approach:
According to this approach, capital structure decision is relevant to the value of the firm.
An increase in financial leverage will lead to decline in the weighted average cost of capital
(WACC), while the value of the firm as well as market price of ordinary share will increase.
Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a
consequent decline in the value as well as market price of equity shares (Chatira and Mwenje,
2018).
 Traditional approach:
This approach f a v o u r s that as a result of financial leverage up to some point, cost of
capital comes down and value of firm increases. However, beyond that point, reverse trends
emerge. The principle implication of this approach is that the cost of capital is dependent on
the capital structure and there is an optimal capital structure which minimizes cost of capital

 Net Operating Income (NOI) approach:
NOI means Earnings before interest and tax (EBIT). According to this approach, capital
structure decisions of the firm are irrelevant. Any change in the leverage will not lead to any
change in the total value of the firm and the market price of shares, as the overall cost of capital
is independent of the degree of leverage (Curuksu, 2018). As a result, the division between
debt and equity is irrelevant. As per this approach, an increase in the use of debt which is
apparently cheaper is offset by an increase in the equity capitalisation rate. This happens because
equity investors seek higher compensation as they are opposed to greater risk due to the
existence of fixed return securities in the capital structure.
 Modigliani-Miller (MM) approach:
The NOI approach is definitional or conceptual and lacks behavioural significance. It
does not provide operational justification for irrelevance of capital structure. However,
Modigliani-Miller (MM) approach provides behavioural justification for constant overall cost of
capital and therefore, total value of the firm. This approach describes, in a perfect capital market
where there is no transaction cost and no taxes, the value and cost of capital of a company
remain unchanged irrespective of change in the capital structure. This approach is based on
further following additional assumptions:
o Capital markets are perfect. All information is freely available and there are
no transaction costs.
o All investors are rational.
o Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business
risk.
o Non-existence of corporate taxes.
However, the following assumptions are made to understand this relationship:
 There are only two kinds of funds used by a firm i.e. debt and equity.
 The total assets of the firm are given (Fatemi and Sabbaghian, 2019). The degree of
leverage can be changed by selling debt to purchase shares or selling shares to retire
debt.
 Taxes are not considered.
 The dividend payout ratio is 100%.
 The firm’s total financing remains constant.

 Business risk is constant over time.
 The firm has perpetual life.
The value of firm will be derived by using the above theories with the help of the following
examples: Using MM approach the firm value can be derived as under: -
Particular Amount
Earnings before interest and tax 500000
Less: Interest on Debentures ( 2000000 * 10 %) (200000)
Earning available of equity holders 300000
Assuming the capitalization rate 16 %
The market value of Equity will be 1875000
The market value of debt is 2000000
The total value of the firm using Modigliani and Millar approach will be: -
= 1875000 + 2000000
= 38,75,000
Therefore, the overall cost of capital will be: -
= EBIT / Value of Firm
= 5,00,000 / 38,75,000
= 12.90 %
The value of firm will be calculated with the help of traditional approach as under using the
example: -
Assuming that the EBIT of the firm is 100000 and the entity makes use of both the debt and
equity capital in its business (Fauzi, Antoni and Suwarni, 2021). The firm is using 10 % of
debentures of 500000 and their equity capitalization rate is 15 %. On the basis of this data the
firm value will be calculated as under: -
Particular Amount
Earnings before interest and taxes 100000
Less Interest ( 10 % of 500000 ) 50000
The earnings available to Equity holders 50000
Equity Capitalization Rate 15 %

The value of Equity using the traditional approach will be as under: -
= Earnings available to equity holders / Cost of Equity
= 50000 / 15 %
= 3,33,333
The value of Debt is given that is 500,000
Therefore, the value of firm will be
= 3,33,333 + 5,00,000
= 8,33,3333
The calculation of value of firm using NOI approach will be calculated as under using the
examples as under:
Assuming that the operating income of the entity is 5,00,000 and their cost of debt is 10 % and
currently the firm employs 15,00,000. The overall cost of capital of the entity is 15 %.
The Value of the firm will be calculated as under:
Particular Amount
Net Operating Income 500000
Less : Interest on Debentures ( 10% of
1500000)
150000
Earnings available for equity holders 350000
The cost of capital will be (Ko) 15 %
The value of the firm will be ( EBIT / Ko ) 500000 / 15 %
Value of firm will be 33,33,333
The calculation of cost of equity: -
Particular Amount
Market value of debt 15,00,000
Market Value of Equity ( 33,33,333 –
15,00,000 )
18,33,333
Feasibility analysis of a optimum structure can be explained as a tool that assists in
looking forward at the practicality of a business project and evaluate related issues as well. It
helps to study present mode of operation related activities, examine the available alternatives and

an agreed set of commands. It guides to get correct answer before spending of any monetary
value and scarce resources as well. It includes a study that takes in account all related factors
such as Technical, legal, economic and other considerations as well. It helps to determine the
chances to complete the planned project well in time and successfully. It is useful to uncover the
weakness, risks and strengths related to objectives set by a existing business in a competitive
environment (Ferdiana and Sulistyo, 2019).
Dividend policy can be explained as amount paid by companies that are seen in a positive
light for both investors and firms as well. The companies that do not make payment towards
dividends are rated adversely by investors and hence it also affects the share prices too.
Relevance theory of dividend can be explained as a aspect that involves argument that decision
related to dividend affects working and functioning of market in business environment. It
therefore, affects the valuation of enterprise in a industry. It further suggests that investors are
usually risk averse and would possibly take dividends at present than practice share appreciation
and dividends afterwards. The relevance theory advise that this sort of policy would affect the
share prices as well (Linh and Mohanlingam, 2018). There are certain models that explains
relevance theory in a better format:
Gordon Approach: It can be explained as a method that stats the importance of bird in the hand
theory related to dividend policy which defines that policyholders are risk averse and prefer to
get dividend pay instead of future capital profits. Shareholder's consider dividend payments to be
more sure than future day capital gain. It further states that payment of current situation
dividends helps to solve investor uncertainty. Investors further have a preference for a specified
level of earning at present rather than that of prospect of a higher but lesser certainty, income at
similar time at future point of time. The assumptions that are followed is that the firm is an
equity based firm, internal rate of return of the organisation remains constant, corporate tax
doesn't exist, growth rate and retention rate is constant, internal rate of return is also constant
(Maisharoh and Riyanto, 2020).
Dividend signalling Theory: It helps to understand and interpret that announcing rising payments
of dividend in a organisation supply powerful signals keeping futuristic expectation of the firm.
In general, alteration in a companies dividend policy can be recorded to have a impact on its
share prices and an rise in dividend that generates a increase in share rates and a fall in dividend
that produce a fall in price of shares. Basically, a increase in payment of dividend is seen as a

positive aspect, that conveys positive data related to a business future earning potential of the
organisation resulting in increase of share prices. In other cases, a fall in payment of dividend is
observed as a adverse result keeping futuristic situation in mind that leads to fall in share prices
as well.
Walter approach: It was given by James E Walter and relies on a simple argument which states
that the reinvestment rate, that is, rate of return that the business might earn on retained earnings
is high when compared to cost of equity, then it can be considered as interest of the business for
retaining the profits earned. If it is observed that enterprise's reinvestment rate is lesser when
compared to equity owner's rate of return, the firm cannot retain the earned amount. If the two
rate percentages are similar then the organisation must be indifferent from distributing and
retaining. It is based on some assumption such as cost of capital and Internal rate of return in
case of enterprise remains same. The business posses a long run in competitive environment,
earning and dividend of company won't differ. The company generate funds and its related
investment with the help of retained earnings (Rafinda and Gal, 2020).
Dividend capitalisation model: Accordant to Gordon, the valuation of a share capital in
marketplace is equivalent to the current price or value of future based dividends. It is tool which
is useful for predicting a enterprise cost of average equity. This approach closely monitor a
future based dividend stream that relies on firm's dividend history and an predicted growth price
that helps to calculate market capitalisation rates which considers it with the present market rate
(Soegoto, Soegoto and Pasha, 2020). In the case of closely held companies such as partnership
and sole traders that usually doesn't dispense revenue earned as dividends, the enterprise
dividend paying capacity is computed from its average cash flow and average net earning when
compared with the dividend actually paid by a related size of a business. It is hence also known
as Growth model (Septyanto and Welandasari, 2020).
CONCLUSION
From the report prepared below it can be concluded that Optimal capital structure is
helpful in running a organisation in a competitive environment. It is helpful to develop
profitability, feasibility, flexibility, solvency and add value in the running & functioning of a
firm. It is useful in finding relevance of a dividend policy in a business and evaluate the value
being served by a company in competitive environment. It helps to get engaged and linked with

the ideology of an optimal capital structure and its implementation towards cost of capital. It also
develops issues and challenges for firms and their appointed managers as exploring each sector is
a difficult task. Such problems can be found better solutions and a way can be observed that
would assist in better development of related policies as well. Such issues can be solved with the
help of some theories such as Gordon's and Growth models. There are many related theories that
are useful in understanding dividend policies and understand how it works and assist in long run
functioning of a company in long term. The report prepared also helps to get an idea about how
to deal with certain areas that involve giving and adding value and worth towards the working,
functioning of a company in competitive business environment.

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