Capital Structure

1. Financial Management
CHAPTER - V
FINANCING DECISION

2. 5.1 Concept of Capital Structure
• “Capital structure is the combination of debt and equity
securities that comprise a firm’s financing of its assets”
– John, J. Hampton.
• It is composition of long term sources of funds such as
ordinary shares, preference shares, bonds, long term
debts etc. It refers to the kind and proportion of
securities for raising long term funds.

3. 5.1.1 Importance of Capital Structure
• It enables a company to raise the requisite funds from various
sources at the lowest possible cost.
• It maximizes the return to the equity shareholders and market
value of share held by them.
• It enables the company to minimize the various business risks by
making suitable adjustments in the components of capital
structure.
• It ensures the retention of control over the affairs of the company
within the hands of existing equity shareholders by maintaining a
proper balance between voting and non-voting right capital.

4. • It enables the company to maintain a proper balance between
fixed and liquid assets and avoid various financial and
managerial difficulties.
• It helps a company to eliminate both the states of
overcapitalization and undercapitalization.
5.1.2 Arbitrage Process
• The term ‘Arbitrage process’ refers to an act of buying an assets
or security in one market having lower price and selling it in
another market at a higher price.
• This process will continue till the market prices of the two
homogeneous firms become identical. Thus, arbitrage process
restores equilibrium in value of securities.

5. 5.1.3 Various Theories of Capital Structure
1. Traditional Approach
 It is also known as intermediate approach, is midway between the NI
and NOI approaches.
 The value of the firm can be increased initially or the cost of capital
can be decreased by using more debts, as the debt is a cheaper source
of fund than equity.
 Optimum capital structure can be reached by a proper debt-equity mix.

6. 2. Net Income Approach (NI)
A firm can minimize the weighted average cost of capital and
increase the value of the firm as well as market price of equity
shares by using debt financing to the maximum possible extent.
Assumptions:
 The cost of debt is less than the cost of equity
 There are no taxes.
 The debt content does not change the risk perception of the
investors.

7. Value of the firm under Net Income Approach
Overall cost of capital, Ko = EBIT / V
Where, EBIT – Earnings before interest and tax;
V – Value of the firm;
Value of the firm, V = S+B
Where, S – Market value of equity;
B - Market value of debt;
S = NI / Ke
Where, NI – Earnings available for equity shareholders;
Ke - Equity capitalization rate;

8. 3. Net Operating Income Approach (NOI)
 Market value of the firm is not at all affected by the capital
structure changes.
 The overall cost of capital remains constant irrespective of
method of financing.
 There is nothing as an optimum capital structure and every
capital structure is the optimum capital structure.
Assumptions
 The market capitalizes the value of the firm as a whole.
 The business risk remains constant at every level of debt equity
mix.
 There is no corporate taxes.

9. Value of the firm under Net Operating Income Approach
Value of the firm, V = EBIT / Ko
Where, EBIT – Earnings before interest and tax;
Ko – Overall cost of capital;
Value of the Equity, S = V – B
Equity capitalization rate, Ke = (EBIT – I) / (V – B)
Where, V – Value of the firm;
B - Market value of debt;
I – Interest;

10. 4. Modigliani and Miller Approach
 The value of a firm is independent of its capital structure.
 Average cost of capital does not change with the change in the
debt weighted equity mix or capital structure of the firm.
 Two identical firms in all respects expect their capital structure
cannot have different market values or cost of capital because of
arbitrage process.
 Two identical firms expect for their capital structure have
different market values or cost of capital, arbitrage will take place
and the investors will engage in “personal leverage” as against the
corporate leverage.

11. Assumptions:
 There are no corporate taxes
 There is a perfect market
 Investors act rationally
 The expected earnings of all the firms have identical risk
characteristics.
 The cut off point of investment in a firm is capitalization rate
 There are no transaction costs
 There are no retained earnings

12. Value of the firm under M – M Approach
Value of the an unlevered firm, Vu = (1-t) EBT / Ke
Where, EBT – Earnings before tax;
Ke – Equity capitalization rate;
T – Tax rate;
Value of levered firm, VL = Vu + Bt
Where, Vu – Value of the an unlevered firm;
B - Value of debt;
T – Tax rate;

13. Example: 1
Apex Ltd., is expecting an annual EBIT of Rs 100,000. The company
has Rs 400,000 in 10% debentures. The cost of equity capital or
capitalization rate is 12.5 %. You are required to calculate the total
value of the firm and also state the overall cost of capital according to
the Net income approach.
Example: 2
A company expects a net operating income of Rs 100,000. It has Rs
500,000 6% debentures. The overall capitalization rate is 10%.
Calculate the value of the firm and the equity capital rate (cost of
equity) according to the Net operating income approach.
Example : 3
Two firms A and B are identical in all respects except the degree of
leverage. Firm A has 6% debt of Rs 300,000, while firm B has no debt.
Both the firms earnings an EBT of Rs 120,000 each. The equity
capitalization rate is 10% and the corporate tax is 60%. Compute the
market value of the two firm under M-M approach.

14. 5.2 Leverages
• “Leverage is the ratio of net returns on share holders equity and
the net rate of return on total capitalization”
– Ezra Soloman.
• The term leverage is used to describe the firms ability to use
fixed cost assets or funds to increase the return to its owners.
5.2.1 Types of Leverages:
1. Operating Leverage
• Operating leverage is the extent to which a firm’s fixed
production costs contribute to its total operating costs at different
levels of sales. In a firm that has operating leverage, a given
change in sales results in a larger change in the net operating
income.

15. • The degree of operating leverage (DOL) measures the percentage
change in NOI for a given percentage change in sales.
Computation of operating leverage:
Operating leverage, OL = Contribution / Operating profit (or)
C / OP (or) C / EBIT
2. Financial Leverage
• Financial leverage measures the sensitivity of the firm’s net
income (NI) to changes in its net operating income (NOI).
• In contrast to operating leverage, which is determined by the
firm’s choice of technology (fixed and variable costs), financial
leverage is determined by the firm’s financing choices (the mix
of debt and equity).

16. • The degree of financial leverage (DFL) measures the percentage
change in net income for a given percentage change in NOI.
Computation of financial leverage:
Financial leverage, FL = Operating profit / Profit before tax (or)
OP / PBT (or) EBIT / PBT
3. Combined Leverage
• Combined leverage measures the overall sensitivity of the firm’s net
income (NI) to a change in sales.
• The degree of combined leverage (DCL) measures the percentage
change in net income for a given percentage change in sales.
Computation of combined leverage:
Combined leverage, CL = Contribution / Profit before tax (or) OL*FL

17. MASTER TABLE TO CALCULATE THE LEVERAGES
Particulars Birr
Sales
Less: Variable cost
xxxx
xxxx
Contribution
Less: Fixed cost
xxxx
xxxx
Operating profit/EBIT
Less: Interest
xxxx
xxxx
PBT or EBT
Less: Tax
xxxx
xxxx
EAT
Less: Preference dividend
xxxx
xxxx
Earnings available to shareholders (EAS) xxxx

18. DISTINGUISH BETWEEN OPERATING LEVERAGE
AND FINANCIAL LEVERAGE
S.No Operating Leverage Financial Leverage
1 Related to the investment
activities
More concerned with financial
matters
2 It is useful to take capital
expenditure decision
It useful for mixing the debt and
equity in the capital structure
3 The fluctuation in the EBIT
can be predicted
The changes of EPS due to the
debt-equity mix is predicted
4 It is used to predict business
risk
It is used to predict the financial
risk

19. Trading on Equity: The use of long term fixed interest bearing debt
and preference share capital along with equity share capital is called
trading on equity.
Earnings per share (EPS): Earnings per share is the amount that the
shareholder can get on every share hold.
EPS = Net profit available to equity shareholders / Number of
ordinary shares outstanding
Example: 4
From the following selected operating data determine the breakeven
sales level and degree of operating leverage.
Variable expenses as a percentage of sales for firm A are 50% and for
firm B are 25%.
Firm A (Rs) Firm B (Rs)
Sales
Fixed cost
2,500,000
750,000
3,000,000
1,500,000

20. Example: 5
A company has the following capital structure: Equity share capital
Rs 100,000; 10% Preference share capital Rs 100,000 and 8%
Debentures Rs 125,000. The present EBIT is Rs 50,000. Calculate
the financial leverage assuming that company is in 50% tax bracket.
Example: 6
From the following data calculate the degree of different leverage.
Sales 100,000 units at Rs 2 per unit; Variable cost per unit @ Rs
0.70; Fixed cost Rs 100,000; Interest charges Rs 3,600.

21. 5.3 Introduction to Financing
• Financing is needed to start a business and ramp it up to
profitability.
• There are several sources to consider when looking for start-up
financing.
• But first you need to consider how much money you need and
when you will need it.
• The financial needs of a business will vary according to the type
and size of the business.
• For example, processing businesses are usually capital intensive,
requiring large amounts of capital. Retail businesses usually
require less capital.

22. • Debt and equity are the two major sources of financing.
• Government grants to finance certain aspects of a business may
be an option. Also, incentives may be available to locate in certain
communities and/or encourage activities in particular industries.
5.3.1 Methods of Financing:
1. Equity Financing
• Equity financing means exchanging a portion of the ownership of
the business for a financial investment in the business.
• The ownership stake resulting from an equity investment allows
the investor to share in the company’s profits.

23. • Equity involves a permanent investment in a company and is not
repaid by the company at a later date.
• The investment should be properly defined in a formally created
business entity.
• An equity stake in a company can be in the form of membership
units, as in the case of a limited liability company or in the form
of common or preferred stock as in a corporation.
• Companies may establish different classes of stock to control
voting rights among shareholders.

24. • Similarly, companies may use different types of preferred
stock. For example, common stockholders can vote while
preferred stockholders generally cannot.
• But common stockholders are last in line for the company’s
assets in case of default or bankruptcy. Preferred stockholders
receive a predetermined dividend before common stockholders
receive a dividend.
2. Debt Financing
• Debt financing involves borrowing funds from creditors with
the stipulation of repaying the borrowed funds plus interest at a
specified future time.
• For the creditors (those lending the funds to the business), the
reward for providing the debt financing is the interest on the
amount lent to the borrower.

25. • Debt financing may be secured or unsecured.
• Secured debt has collateral (a valuable asset which the lender can
attach to satisfy the loan in case of default by the borrower).
• Conversely, unsecured debt does not have collateral and places
the lender in a less secure position relative to repayment in case of
default.
• Debt financing (loans) may be short term or long term in their
repayment schedules.
• Generally, short-term debt is used to finance current activities
such as operations while long-term debt is used to finance assets
such as buildings and equipment.

26. 3. Lease Financing
• A lease is a method of obtaining the use of assets for the business
without using debt or equity financing.
• It is a legal agreement between two parties that specifies the
terms and conditions for the rental use of a tangible resource such
as a building and equipment.
• Lease payments are often due annually. The agreement is usually
between the company and a leasing or financing organization and
not directly between the company and the organization providing
the assets. When the lease ends, the asset is returned to the
owner, the lease is renewed, or the asset is purchased.

27. • A lease may have an advantage because it does not tie up funds
from purchasing an asset.
• It is often compared to purchasing an asset with debt financing
where the debt repayment is spread over a period of years.
• However, lease payments often come at the beginning of the
year where debt payments come at the end of the year.
• So, the business may have more time to generate funds for debt
payments, although a down payment is usually required at the
beginning of the loan period.
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