Factors influencing capital structure
Optimal capital structure
Point of Indifference
Reasons for changes in capital structure
Types of leverages
“ Capital structure of a company refers to the composition of its capitalisation and it includes all
long term capital sources i.e., loans, reserves, shares and bonds”. –Gerestenbeg
“ the Capital structure of business can be measured by the ratio of various kinds of permanent
loan and equity capital to total capital”. - Schwarty
Factors affecting capital structure
Growth and stability
Cost of capital
Purpose of finance
Size of the company
Nature of the industry
Cost of inflation
Period of finance
Level of interest rate
Level of business activity
Availability of funds
Level of stock prices
Conditions of the capital market
Optimal capital structure
The OCM can be defined as “ that capital structure or combination of debt and equity that leads
to the maximum value of the firm”
OCM maximises the value of the company and hence the wealth of its owners and minimise the
company’s cost of capital.
the following consideration should be kept in mind while maximising the value of the firm in
achieving the goal of the optimal capital structure:
1. If ROI > the fixed cost of funds, the company should prefer to raise the funds having a
fixed cost, such as, debentures, Loans and PSC. It will increase EPS and MV of the firm.
2. If debt is used as a source of finance, the firm saves a considerable amount in payment of
tax as interest is allowed as a deductible expense in computation of tax.
3. It should also avoid undue financial risk attached with the use of increased debt financing
4. The Capital structure should be flexible.
Point of indifference / Range of earnings
The earnings per share, ‘equivalent point’ or ‘point of indifference’ refers to that EBIT, level at
which EPS remains the same irrespective of Different alternatives of Debt-Equity mix. At this
level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also
known as the break-even level of EBIT for alternative financial plans
CG means the ratio between the various types of securities in the capital structure of the
company. A company is said to e high-gear when it has proportionately higher/larger issue of
Debt and PS for raising the LT resources. Whereas low-gear stands for a proportionately large
issue of equity shares.
Leverage-an Increased means of accomplishing some purpose
In financial management, it is the firms ability to use fixed cost assets or funds to increase the
returns to its owners;
Financial leverage- the use of long term fixed income bearing debt and preference share capital
along with the equity share capital is called financial leverage or trading on equity
A Firm is known to have a favourable leverage if its earnings are more than what debt would
cost. On the contrary, if it does not earn as much as the debt costs then it will be known as an
Impact of financial leverage
When the d/f b/w the earnings from assets financed by fixed cost funds and cost of these funds
are distributed to the equity stockholders, they will get additional earnings without increasing
their own investment. Consequently, the EPS and the Rate of return on ESC will go up.
On the contrary, if the firm acquires fixed cost funds at a higher cost than the earnings from
those assets then the EPS and return on equity capital will decrease.
Significance of financial leverage
Planning of capital structure
Limitations of FL/ trading on equity
Beneficial only to companies having stability in earnings
Increases risk and rate of interest
Restriction from financial instruments
Operating leverage results from the presence of fixed costs the help in magnifying net operating
income fluctuations flowing from small variations in revenue.
The changes in sales are related to changes in the revenue. The fixed costs do not change with
the changes in sales, any increase in sales, FC remaining the same, will magnify operating
OL shows the ability of a firm to use fixed operating cost to increase the effect of change in sales
and the charges in fixed operating income.
The OL affects the income which is the result of production. On the other hand, FL is the
result of financial decisions. The CL focuses attention on the entire income of the
This leverage shows the relationship between a change in sales and the corresponding
variation in taxable income.
Working capital leverage
This leverage measures the sensitivity of ROI of changes in the level of current assets.