capital structure

1. CAPITAL
STRUCTURE

2. Overview
 A firm needs funds for long term requirements and working capital.
 These funds are raised through different sources both short term and long
term.
 The long term funds required by a firm are mobilized through
 owners funds (equity share, preference shares and retained earnings) and
long term debt (debentures and bonds). A mix of various long term
sources of funds employed by a firm is called capital structure.
According to Gerestenberg, “Capital structure of a company refers
to the composition or make-up of its capitalization and it includes all
long term capital resources, viz, loans, bonds, shares and reserves”
 Thus capital structure is made up of debt and equity securities and refers
to permanent financing of a firm.

3. Features & Benefits
 Financial Manager has to plan the appropriate mix of different securities in
total capitalization in such a way as to minimize the cost of capital and
maximize the earnings per share to the equity shareholders.
 There may be four fundamental patterns of capital structure as follows:
(i) Equity capital only(including Reserves and Surplus)
(ii) Equity and preference capital
(iii) Equity, preference and long term debt i.e. debentures, bonds and loans
from financial institutions etc.
iv. Equity and long term debt.

4. Financial Structure Vs. Capital Structure
 Financial structure refers to the way in which the total assets of a firm
are financed. In other words, financial structure refers to the entire
liabilities side of the Balance Sheet.(concerns the entire "Liabilities +
Equities" side of the balance sheet)
 financial structure provides more reliable information regarding the
business's current circumstances.
 capital structure represents only long term sources of funds and
excludes all short term debt and current liabilities.
 capital structure can be seen as a subset of the financial structure that is
more geared toward long-term analysis,
 Thus, financial structure is a broader one and capital structure is only part
of it.

5. Features of An Appropriate Capital Structure
(i) Profitability: The capital structure of the company should be most
profitable. The most profitable capital structure is one that tends to
minimize cost of financing and maximize earnings per equity share.
(ii) Solvency: The pattern of capital structure should be so devised as to ensure
that the firm does not run the risk of becoming insolvent. Excess use of
debt threatens the solvency of the company. The debt content should not,
therefore, be such that which increases risk beyond manageable limits.
(iii) Flexibility: The capital structure should be flexible to meet the requirements
of changing conditions. Moreover, it should also be possible for the
company to provide funds whenever needed to finance its profitable
activities.

6. Features of An Appropriate Capital Structure
(iv) Conservatism: The capital structure should be conservative in the sense that
the debt content in the total capital structure does not exceed the limit which
the company can bear. In other words, it should be such as is commensurate
with the company’s ability to generate future cash flows.
(v) Control: The capital structure should be so devised that it involves minimum
risk of loss of control of the company.

7.  Capital Structure decision will decide weight of Debt and Equity
and ultimately overall cost of capital as well as value of firm.
 So Capital structure is relevant in maximizing value of firm and
minimizing overall cost of capital.
 Demand for raising funds generates a new capital Mix since a
decision has to be made as to the quantity and forms of
financing.

8. Process of financing Capital Structure Decision

9. Theories of Capital Structure
 There are two extreme views or schools of thought regarding the existence
of an optimum capital structure.
 As per one view, capital
 structure influences the value of the firm and cost of capital and hence there
exists an optimum relevance and hence there exists an optimum capital
structure.
 On the other hand, the other school of thought advocates that capital
structure has no relevance and it does not influence the value of the firm
and cost of capital.
 Reflecting these views, different theories of capital structure have been
developed.
 The main contributors to the theories are David Durand, Ezra Solomon,
Modigliani and Miller.

10. Theories of Capital Structure

11. These theories and the relationship between capital
structure and value of the firm or cost of capital, the
following assumptions are made
 There are only two kind of Firms ie. Debt & Equity
 The total assets of the firm are given.
 The firm has 100% payout ratio, i.e., it pays 100% of its earnings as
dividends.
 The operating earnings (EBIT) of the firm are not expected to grow.
 There are no corporate and personal taxes. This assumption it relaxed
later
 Investors have the same subjective probability distribution of expected
future operating earnings for a given firm.

12. EBIT-EPS analysis
 EBIT-EPS analysis gives a scientific basis for comparison among
various financial plans and shows ways to maximize EPS.
 Hence EBIT-EPS analysis may be defined as ‘a tool of financial
planning that evaluates various alternatives of financing a project
under varying levels of EBIT and suggests the best alternative
having highest EPS and determines the most profitable level of
EBIT’.

13. Concept of EBIT-EPS Analysis:
 The EBIT-EBT analysis is the method that studies the leverage,
i.e. comparing alternative methods of financing at different
levels of EBIT. Simply put, EBIT-EPS analysis examines the effect
of financial leverage on the EPS with varying levels of EBIT or
under alternative financial plans.
 It examines the effect of financial leverage on the behavior of
EPS under different financing alternatives and with varying levels
of EBIT.

14. Concept of EBIT-EPS Analysis
 EBIT-EPS analysis is used for making the choice of the
combination and of the various sources. It helps select the
alternative that yields the highest EPS.
 a firm can finance its investment from various sources such as
borrowed capital or equity capital. The proportion of various
sources may also be different under various financial plans. In
every financing plan the firm’s objectives lie in maximizing EPS.

15.  Suppose, ABC Ltd. which is expecting the EBIT of Rs.1,50,000 per
annum on an investment Rs.5,00,000, is considering the
finalization of the capital structure or the financial plan. The
company has access to raise funds of varying amounts by issuing
equity share capital, 12% preference share and 10% debenture or
any combination thereof. Suppose, it analyzes the following four
options to raise the required funds of Rs.5,00,000.

16.  1. By issuing equity share capital at par.
 2. 50% funds by equity share capital and 50% funds by
preference shares.
 3. 5% funds by equity share capital, 25% by preference shares
and 25% by issue of 10% debentures.
 4. 25% funds by equity share capital, 25% as preference share
and 50% by the issue of 10% debentures.
 Assuming that ABC Ltd. belongs to 50% tax bracket, the EPS
under the above four options can be calculated as follows:
 LeverageBook1.xlsx

17.  The financial plan under option 4 seems to be the best as it is giving
the highest EPS of 38.
 In this plan, the firm has applied maximum financial leverage. The firm
is expecting to earn an EBIT of Rs.1,50,000 on the total investment of
Rs.5,00,000 resulting in 30% return.
 On an after-tax basis, this return comes to 15% i.e., 30% x (1-
.5). However, the after tax cost of 10% debentures is 5% i.e., 10% (1- .5)
and the after tax cost of preference shares is 12% only.
 In the option 4, the firm has employed 50% debt, 25% preference
shares and 25% equity share capital, and the benefits of employing 50%
debt (which has after tax cost of 5% only) and 25% preference shares
(having cost of 12% only) are extended to the equity shareholders.
 Therefore the firm is expecting an EPS of Rs.38.

18.  What is 'Return on Investment (ROI)'
 Return on Investment (ROI) is a performance measure, used to evaluate
the efficiency of an investment or compare the efficiency of a number
of different investments. ROI measures the amount of return on an
investment, relative to the investment’s cost. To calculate ROI, the
benefit (or return) of an investment is divided by the cost of the
investment. The result is expressed as a percentage or a ratio.


19.  In case, the company opts for all-equity financing only, the EPS is
Rs.15 which is just equal to the after tax return on
investment. However, in option 2, where 5% funds are obtained
by the issue of 12% preference shares, the 3% extra is available to
the equity shareholders resulting in increase in of EPS from Rs.15
to Rs.18. In plan 3, where 10% debt is also introduced, the extra
benefit accruing to the equity shareholders increases further
(from preference shares as well a from debt) and the EPS further
increases to Rs.21.50. The company is expecting this increase in
EPS when more and more preference share and debt financing is
availed because the after tax cost of preference shares and
debentures are less than the after tax return on total investment.

20.  Hence, the financial leverage has a favourable impact on the EPS-
only if the ROI is more than the cost of debt. It will rather have
an unfavourable effect if the ROI is less than the cost of
debt. That is why financial leverage is also called the twin-edged
sword.

21. Factors affecting Capital Stracture
 (1) Cash Flow Position: While making a choice of the capital
structure the future cash flow position should be kept in mind.
 (2) Interest Coverage Ratio-ICR:this ratio an effort is made to
find out how many times the EBIT is available to the payment of
interest. The capacity of the company to use debt capital will be
in direct proportion to this ratio.

22.  (3) Debt Service Coverage Ratio-DSCR:This ratio removes the
weakness of ICR. This shows the cash flow position of the
company.
 This ratio tells us about the cash payments to be made (e.g.,
preference dividend, interest and debt capital repayment) and
amount of cash available. Better ratio means the better capacity
of the company for debt payment. Consequently, more debt can
be utilised in the capital structure.

23.  (4) Return on Investment-ROI:The greater return on investment
of a company increases its capacity to utilise more debt capital.
 (5) Cost of Debt:The capacity of a company to take debt
depends on the cost of debt. In case the rate of interest on the
debt capital is less, more debt capital can be utilised and vice
versa.

24.  (6) Tax Rate:The rate of tax affects the cost of debt. If the rate of
tax is high, the cost of debt decreases. The reason is the
deduction of interest on the debt capital from the profits
considering it a part of expenses and a saving in taxes.
 (7) Cost of Equity Capital:Cost of equity capital (it means the
expectations of the equity shareholders from the company) is
affected by the use of debt capital. If the debt capital is utilised
more, it will increase the cost of the equity capital. The simple
reason for this is that the greater use of debt capital increases
risk of the equity shareholders.

25.  (8) Floatation Costs:Floatation costs are those expenses which
are incurred while issuing securities (e.g., equity shares,
preference shares, debentures, etc.). These include commission
underwriters, brokerage, stationery expenses, etc
 (9) Risk Consideration: There are two types of risks in business:(i)
Operating Risk or Business Risk:This refers to the risk of inability
to discharge permanent operating costs (e.g., rent of the
payment of salary, insurance installment, etc),

26.  (ii) Financial Risk: This refers to the risk of inability to pay fixed
financial payments (e.g., payment of interest, preference
return of the debt capital, etc.) as promised by the company.
 (10) Flexibility:According to this principle, capital structure should
be fairly flexible. Flexibility means that, if need be, amount of
capital in the business could be increased or decreased easily.
Reducing the amount of capital in business is possible only in
case of debt capital or preference share capital.

27.  (11) Control:According to this factor, at the time of preparing
capital structure, it should be ensured that the control of the
existing shareholders (owners) over the affairs of the company is
not adversely affected.
 (12) Regulatory Framework:Capital structure is also influenced by
government regulations. For instance, banking companies can
raise funds by issuing share capital alone, not any other kind of
security. Similarly, it is compulsory for other companies to
maintain a given debt-equity ratio while raising funds.