CAPITAL STRUCTURE

Compiled to Fulfill the Duties of Financial Management Courses

Lecturer: Prof. Dr. Isti Fadah, M.Si.

Authored By:

Yossy Eka Pradita (190810201146)

Galuh Dewandaru Al Amanah (190810201154)

DEPARTMENT OF MANAGEMENT
FACULTY OF ECONOMICS AND BUSINESS
THE UNIVERSITY OF JEMBER
2021
 CHAPTER I
INTRODUCTION

1.1 Background
One of the important decisions faced by financial managers in relation to
the company's operations is the decision on the Capital Structure, which is a
financial decision related to the composition of debt, prefen shares and common
shares that must be used by the company.
The decision of the Capital Structure directly affects the amount of risk
borne by shareholders along with the amount of return or the expected level of
profit. Capital Structure decisions taken by the manager not only affect the
profitality of the company but also affect the risks faced by the company.
Capital Structure is a funding option between debt and equity. Theories
that explain this include Trade-Off Theory, Pecking Order Theory, and other
Theories.

1.2 Problem Formulation

1. What is the definition of capital structure according to experts?
2. How is the capital structure viewed from financial leverage?
3. What is the optimal capital structure?
4. What influences capital structure decisions?
5. How is the theory of capital structure?
6. How is the checklist of capital structure decisions?

1.3 Purpose
1. Know the definition of capital structure according to experts.
2. Know the capital structure viewed from financial leverage.
3. Know the optimal of capital structure.
4. Know what influences capital structure decisions.
5. Know the theory of capital structure.
6. Know how the checklist capital structure decisions.
 CHAPTER II
DISCUSSION

2.1 Definition of Capital Structure According to Experts

According to Weston and Copeland that the capital structure or the
capitalization of the firm is the permanent financing represented by long-term
debt, preferred stock and shareholder's equity. Meanwhile, Joel G. Siegel and Jae
K. Shim say the Capital Structure is a composition of common stock, preferred
stock, and various such classes, retained earnings, and long-term debt maintained
by the business entity in funding assets.
So it can be understood that the capital structure is a picture of the form of
financial proportion of the company, namely between the capital that has been
sourced from long-term liabilities and the shareholders' equity that becomes the
source of financing of a company.
The capital structure of a company consists of long-term debt and
shareholders' equity, where the stockholder equity consists of preferred stock and
common equity, and common equity itself is composed of common stock and
retained earnings.

2.2 Understanding Capital Structure in Leveraged Finance

1. The structure of assets is reflected in the right side of a balance sheet,
which indicates the composition of assets to be financed.
2. The financial structure is reflected in the right side of a balance sheet,
which reflects the composition of the source of funds used to finance the
company's assets.
3. The capital structure is indicated by long-term debt and preferred shares
with their own capital outside of short-term debt. The capital itself includes
common stock capital, surplus capital and retained earnings.
 4. Financial leverage or leverage factor is the ratio between debt (B) to total
assets (TA) or total value of the company (V). The ratio of debt to ordinary
shares can also be calculated by ratio: B/S = B/V + (1-B/V)
For example, if :
B/V = 50%, B/S = 0.50/0.50 = 1.00
B/V = 25%, B/S = 0.25/0.75 = 0.33
B/V = 60%, B/S = 0.60/0.40 = 1.50

2.3 Optimal Capital Structure

An optimal capital structure is a structure that maximizes the company's
price, and it typically asks for a lower debt ratio than the ratio that maximizes the
expected EPS. In other words the optimal capital structure is the point where k0 is
at its lowest point. In the position of the optimal capital structure, not only the
weighted average of the company's capital costs reaches the lowest point, but the
total value of the company also reaches the highest point. This is because the
lower the capitalization rate, the k0 used in the company's net operating profit
flow, the higher the net present value of the current. So the optimal capital
structure is a capital structure that minimizes the company's capital costs so as to
maximize the value of the company. Thus, the Optimal Capital Structure is a
capital structure that maximizes EBIT / EPS, maximizes the share price, and
minimizes the capital biya / WACC.
The difficult thing is to estimate how a change in the capital structure will
affect the share price. But it turns out that the capital structure that can maximize
the share price is the capital structure that can minimize the WACC. As it is
usually easier to predict how changes in capital structure will affect the WACC
than share prices, most managers use predicted WACC changes to help them
make capital structure decisions.
Each company at the initial stage of standing certainly requires capital for
the determination of its capital structure, and at the time will expand the business
or merge its business will most likely make changes in the capital structure caused
by changes in capital or additional capital. Two things that companies must do,
First determine the amount of quantitative capital needs (Capitalization process).
Second, determine qualitative capital source / type of capital to be withdrawn (the
process of determining the Capital Structure. To determine the Capital Structure
the company is faced with a variety of variables that affect it. There are 10
variables that may affect: interest rate, sales stability, sales growth rate, asset
structure, risk level of assets, capital needs, rival structure, capital market
situation, management attitude, and lender attitude.
For companies the best capital structure structure is said to be the
Optimum Capital Structure. The optimum capital structure according to the
conservative approach is a capital structure that uses a maximum loan capital of
50% of the total capital. While according to the approach of capital cost of
optimum capital structure is a capital structure that can minimize the average cost
of capital of the company.
This method of capital cost can be analyzed with a variety of approaches,
and the approach chosen on this issue is the Traditional Approach which states
that the optimum capital structure will occur in conditions of average minimum
capital cost and maximum corporate value. Here must be done an analysis of the
variables that affect the capital structure of the company and its relationship with
the determination of the value of the company. So it must be determined:
1. Dominant variables to the capital structure using Factor Analysis.
2. Determine the maximum company value.
According to Maness (1988), there are several factors that influence the
determination of the optimal capital structure, namely:
1. Sales Stability
Companies with relatively stable sales can be safer to obtain more loans
and bear a higher fixed burden compared to companies whose sales are unstable.
2. Operating Leverage
Companies that reduce the leverage of their operations are better able to
increase the use of financial leverage (debt).
3. Corporate Taxes
 Because of the tax-deductable interest, there is an advantage when using
debt. Marginally higher corporate tax rates, then the benefits of using debt will be
higher, all others are considered the same.

4. Risk Level of Assets

The level or level of risk of each asset in the company is not the same. The
longer the period of use of an asset in the company, the greater the degree of risk.
And the continuous development and advancement of technology and science, in
an economic sense can accelerate the disusion of an asset, although in a technical
sense it can still be used.
5. Lenders and Rating Agencies
If companies use excess debt, lenders will start asking for higher interest
rates and rating agencies will start lowering the rating on the company's debt
levels.
6. Internal Cash Flow
A higher and more stable internal level of cash flow can identify a more
stable level of leverage.
7. Control
Many companies are now increasing their debt levels and starting by
issuing new debt to repurchase outstanding commonstock. The purpose of the
debt increase is to get a higher return,, while the share buyback aims to further
increase the level of control.
8. Economic conditions
Economic conditions such as today and also conditions in financial
markets can affect capital structure decisions. When interest rates are high,
perhaps funding decisions lead more to short-term debt, and will be refinanced
with long-term debt or equity if market conditions allow.
9. Management preferences
Management preference for risk and management style have a role in
relation to the combination of debt-equity companies in their capital structure.
 10. Debt covenant
Money borrowed from a bank as well as the issuance of debt securities and
realized through a series of agreements (debt covenant).

11. Agency cost

Agency cost is a lowered fee to monitor the activities of management to
ensure that their activities are in line with the agreement between managers,
creditors and also shareholders.
12. Profitability
Companies with high profitability, and greater use of internal financing
can decrease the use of debt (debt ratio).
In certain cases, it turns out that the conditions can be grouped on 4
dominant factors towards the determination of capital structure, namely:
Factor 1: Stability of income and capital needs, variable components:
Sales stability and capital requirements. With the dominant variable is the need for
capital.
Factor 2: Variable industrial market structure; structure, interest rate,
sales growth rate, and risk level of assets. The dominant variable is the structure
of rivals.
Factor 3: Business and financial risks, which consist of variables;
attitude of lenders, the arrangement of assets, and the attitude of management. The
dominant variable is the attitude of lenders.
Factor 4: The economic situation consists only of variable capital
market circumstances, so the dominant variable is the variable state of the capital
market.
For the determination of the value of the company by using the Traditional
approach as a financial management tool, obtained the result that the value of the
company will increase with the average cost of capital of the company through the
way the company borrows capital. And the capital structure applied must have a
maximum debt ratio so as to achieve the optimum capital structure. To determine
the optimum capital structure, the concept of cost of capital is used (bond debt,
new stock emissions, common stock, retained earnings, and weighted average cost
of capital). And the optimum capital structure is achieved when the weighted
average capital cost is low. Because this capital cost is related to profitability, then
at the time of optimum capital structure is also taken into account the level of
profitability by means of ROA and ROE.
To calculate the amount of capital costs in relation to the capital structure
and the value of the company are used the following formulas :
1. The first formula to calculate the return of bonds:
Ki = I/B.
Where:
I = annual debt interest
B = Market value of outstanding bonds
Ki = Return of bonds

2. The second formula to calculate the return of ordinary shares:

To = E/S
Where::
E = Profit for common shareholders
S = Common stock market value in circulation
To = Return of common stock

3. The third formula for counting the company's net return:

Ko = O/V
Where::
O = Net operating profit
V = Total Company Value
Ko = Net return of the company
The optimal capital structure should put the interests of shareholders first.
Therefore, the first time the company should fund its business with internal
financing derived from retained earnings and depreciation on its fixed assets.
Retained earnings are the first alternative used to finance the company's activities.
This first alternative tends to not meet the needs of funds needed by the
company in developing its business, so it is inevitable that the company needs
external financing to meet the needs of its funds.
The second alternative is External financing (external funding can be in
the form of debt, as well as issuing shares). Companies can obtain resources from
investors for shares that the company sells to the public. The Company may issue
a number of common shares to meet its capital needs. But some things that must
be considered by the company, because more and more shares in circulation will
decrease the value of the company.
The decline in the value of the company means a fall in its share price,
because investors think that if the company issues new shares it means a signal to
investors that the company has an unfavorable prospect. If the issuance of shares
causes negative signals to investors regarding its view of the company, then the
company will try to avoid selling shares and prefer to acquire new capital in other
ways, including using debt outside the normal capital structure target.
Here the company utilizes debt in the form of issuing bonds, taking out
loans at banks or other institutions. In taking a debt policy, a financial manager
should consider the benefits and costs of using debt against its capital structure.
The use of debt results in an increase in EBIT flowing to investors, so the larger
the company's debt, the higher its value and the company's share price. The
company's share price will reach its maximum point when all its funding is in
debt, but no company uses one hundred percent of the debt because the company
takes into account the cost of bankruptcy and reduces the costs of the bankruptcy.
Brigham and houston added that there was additional reksiko charged to
ordinary shareholders as a result of the decision to obtain funding through debt.
To explain this for example there are 10 people who will form a company that
will produce computers, assume the company will be capitalized with 50 percent
debt and 50 percent equity, with five investors putting their capital as debt and the
other five putting their money as equity.
 In this case, five investors will bear the entire risk of the company's
business, so ordinary shares will be twice as risky as companies funded only with
equity. So the use of debt concentrates the company's business risk to its
shareholders.
Therefore I think the company is very necessary to take into account the
benefits and costs of using debt considering the company aims to maximize the
welfare of shareholders so the company must be more selective in choosing
financing institutions, interest rates, types of debt.
As well as the ability of financial managers to foresee sales, profit after tax
indicates the company's ability to pay its debts given that shareholders bear
substantial risks due to the use of debt in the event of bankruptcy.

2.4