Chapter20 capital structure_decision

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  • 1. CAPITAL STRUCTURE DECISION © Centre for Financial Management , Bangalore
  • 2. OUTLINE • EBIT – EPS Analysis • ROI – ROE Analysis • Ratio Analysis • Leverage Analysis • Cash Flow Analysis • Comparative Analysis • Guidelines for Capital Structure Planning • Capital Structure Policies in Practice © Centre for Financial Management , Bangalore
  • 3. EBIT – EPS ANALYSIS The relationship between EBIT and EPS is as follows: (EBIT – I) (1 – t) EPS = n © Centre for Financial Management , Bangalore
  • 4. EARNINGS PER SHARE UNDER ALTERNATIVE FINANCING PLANS Equity Financing Debt Financing EBIT : 2,000,000 EBIT : 4,000,000 EBIT : 2,000,000 Interest Profit before taxes Taxes Profit after tax Number of equity shares Earnings per share EBIT : 4,000,000 2,000,000 1,000,000 1,000,000 4,000,000 2,000,000 2,000,000 1,400,000 600,000 300,000 300,000 1,400,000 2,600,000 1,300,000 1,300,000 2,000,000 0.50 2,000,000 1.00 1,000,000 0.30 1,000,000 1.30 © Centre for Financial Management , Bangalore
  • 5. BREAK-EVEN EBIT LEVEL The EBIT indifference point between two alternative financing plans can be obtained by solving the following equation for EBIT* (EBIT *– I1) (1 – t) (EBIT *– I2) (1 – t) = n1 n2 © Centre for Financial Management , Bangalore
  • 6. ROI – ROE ANALYSIS ROE = [ROI + (ROI – r) D/E] (1 – t) where ROE = return on equity ROI = return on investment r = cost of debt D/E = debt-equity ratio t = tax rate © Centre for Financial Management , Bangalore
  • 7. LEVERAGE ANALYSIS • There are two kinds of leverage, viz., operating leverage and financial leverage. • Operating leverage arises from the firm’s fixed operating costs. • Financial leverage arises from the firm’s fixed financing costs. © Centre for Financial Management , Bangalore
  • 8. INCOME STATEMENT FORMAT Sales Operating leverage Financial leverage Less: Variable costs Less: Fixed operating costs Contribution before interest and tax Less: Interest on debt Profit before tax Less: Tax Profit after tax Less: Preferred dividend Equity earnings © Centre for Financial Management , Bangalore Total leverage
  • 9. CERTAIN RELATIONSHIPS PBIT = Q (P – V) – F PAT = (PBIT – I) ( 1 – T) EPS = (PBIT – I) (1 – T) – Dp N = [Q (P – V) – F – I] (1 – T) – Dp N © Centre for Financial Management , Bangalore
  • 10. OPERATING LEVERAGE The sensitivity of profit before interest and taxes (PBIT) to changes in unit sales is referred to as the degree of operating leverage (DOL). Δ PBIT/PBIT DOL = ΔQ/Q Q (P – V) = Q (P – V) – F Contribution = Profit before interest and tax © Centre for Financial Management , Bangalore
  • 11. FINANCIAL LEVERAGE The sensitivity of profit before tax (or profit after tax or earnings per share) to changes in PBIT is referred to as the degree of financial leverage. Δ PBT / PBT DFL = PBIT = Δ PBIT / PBIT PBIT – I Profit before interest and tax = Profit before tax © Centre for Financial Management , Bangalore
  • 12. TOTAL LEVERAGE The sensitivity of profit before tax (or profit after tax or earnings per share) to changes in unit sales is referred to as the degree of total (or combined) leverage (DTL). Δ PBT / PBT DTL = Q (P – V) = ΔQ/Q = PBIT – T Contribution Profit before tax DTL = DOL x DFL © Centre for Financial Management , Bangalore
  • 13. RATIO ANALYSIS Interest Coverage Ratio Earnings before interest and taxes Interest on debt  Cash Flow Coverage Ratio EBIT + Depreciation + Other non-cash charges Interest on debt + Loan repayment instalment (1 – Tax rate) © Centre for Financial Management , Bangalore
  • 14. RATIO ANALYSIS n ∑ PATi + DEPi + INTi + Li i=1 DSCR = n ∑ INTi + LRIi + Li i=1 where DSCR = debt service coverage ratio PATi = profit after tax for year i DEPi = depreciation for year i INTi = interest on long-term loan for year i LRIi = loan repayment instalment for year i Li = lease rental for year i = period of the loan n © Centre for Financial Management , Bangalore
  • 15. CASH FLOW ANALYSIS The key question in assessing the debt capacity of a firm is whether the probability of default associated with a certain level of debt is acceptable to the management. The cash flow analysis establishes the debt capacity by examining the probability of default. © Centre for Financial Management , Bangalore
  • 16. INVENTORY OF RESOURCES It would be helpful to supplement cash flow analysis by estimating potential sources of liquidity available to the firm to meet possible cash drains. These sources, as suggested by Gordon Donaldson, may be divided into three categories: • Uncommitted reserves • Reduction of planned outlays • Liquidation of assets © Centre for Financial Management , Bangalore
  • 17. COMPARATIVE ANALYSIS • A common approach to analysing the capital structure of a firm is to compare its debt-equity ratio to the average debt-equity ratio of the industry to which the firm belongs. • Since the firms in an industry may differ on factors like operating risk, profitability, and tax status it makes sense to control for differences in these variables. © Centre for Financial Management , Bangalore
  • 18. GUIDELINES FOR CAPITAL STRUCTURE PLANNING • Avail of the tax advantage of debt • Preserve flexibility • Ensure that the total risk exposure is reasonable • Examine the control implications of alternative financing plans • Subordinate financial policy to corporate strategy • Mitigate potential agency costs © Centre for Financial Management , Bangalore
  • 19. GUIDELINES FOR CAPITAL STRUCTURE PLANNING • Resort to timing judiciously • Finance proactively not reactively • Know the norms of lenders and credit rating agencies • Issue innovative securities • Widen the range of financing sources • Communicate intelligently with investors © Centre for Financial Management , Bangalore
  • 20. CAPITAL STRUCTURE POLICIES Five common policies are: A. No debt should be used B. Debt should be employed to a very limited extent C. The debt-equity ratio should be maintained around 1:1 D. The debt-equity ratio should be kept within 2:1 E. Debt should be tapped to the extent available © Centre for Financial Management , Bangalore