theories of capital structure

1. Form of Capital:
Capital Structure

2. Capitalization
Capital
Structure
Financial
Structure
Terminologies

3. Total
amount
of
(in
)
issued by a
Current Liabilities Current Assets
Debt
Preference Shares
Fixed Assets
Equity Shares
Retained Earnings
Balance Sheet

4. Capital Structure =
Financial
Structure
Current
liabilities

5. Equity Share Capital
+ Retained Earnings
Debt + Preference
Share
Debt
Foundatio
n
Expansio
n
Horizontal
Vertical
Pyramid
Shaped
Inverted
Pyramid
Shaped

6. Importance of Capital
Structure:

8.  Level of EBIT which is just equal to pay the total financial charges.
 At this point EPS = 0.
 Critical point in planning capital structure of firm.
 If EBIT < financial break even point, then debt and preference share capital
should be reduced in capitalization.
 If EBIT> financial break even point more of fixed cost may be inducted in
capital structure.
Financial Break-Even Point

9. • Financial Break Even Point
= Fixed Interest Charges
When capital
structure consists
of debt and equity
share capital and
no preference
share capital
• Financial break even point=
I+ Dp
• (1-t)
• here, I = fixed interest charges
• Dp = preference dividend
• t = tax rate
When capital
structure consists
of equity share
capital, preference
share capital and
debt

10. Point of Indifference/ Range of Earnings
 It is EBIT level at which
EPS remains the same ;
irrespective of different alternatives of debt-equity mix.
 At this level of EBIT,
rate of return on capital employed = cost of debt.

11.  Calculation of Point of Indifference (algebraically):
(X-I1) (1-T) – PD =
S1
(X-I2) (1-T)- PD
S2
WHERE, X = point of indifference,
I1 = interest under alternative financial plan 1,
I2 = interest under alternative financial plan 2,
T= tax rate,
S1 = no of equity shares under financial plan1,
S2 = no of equity shared under financial plan 2,
PD= preference dividend.

12. A project under consideration by your company requires a
capital investment of 60 lakhs. Interest on loan 10 % p.a
and tax rate 50%. Calculate point of indifference for the
project, if debt equity ratio is 2:1.

13. As debt equity ratio is 2:1. So, Company has two alternatives :
(i) Raising entire amount by issue of share capital and no debt.
(ii) Raising 40 lakh by way of debt and 20 lakh by issue of equity
share capital.
Calculation of point of indifference:
(X-I1) (1-T) – PD = (X-I2) (1-T)- PD
S 1 S2
I1 = 0 , I2 = 40* 10% = 4 , tax rate = 50 % or .5 , S1= 60, S2 = 20
now substitute the values,
(X-0) (1-0.5) – 0 = (X-4) (1-0.5) – 0
20
60
20 (.5X) = 60 (.5X-2)
10X = 30X-120
X=6
Thus, EBIT at point of indifference is 6 lakhs.

14. Graphically :
0
0.4
0.2
0.6
1.2
1
0.8
1 2 3 4 5 6 7
Plan 1
Plan 2
EPS
(Rs.)
EBIT (Rs. In lakhs)
Indifference point
8 9 10

15. Point of indifference and
uncommitted earnings per share
Equivalency point for uncommitted EPS can be calculated as below:
(X-I1) (1-T) –PD-SF = (X-I2) (1-T)- PD- SF
S1 S2
where, X = Equivalency point or point of indifference
I1 = interest under alternative financial plan 1,
I2 = interest under alternative financial plan 2,
T= tax rate,
S1 = no of equity shares under financial plan1,
S2 = no of equity shared under financial plan 2,
PD= preference dividend.
SF= sinking fund obligations

16. Optimal Capital Structure

17. Considerations to be kept in mind while
maximising value of firm:

18. Risk-Return Trade Off

19. Capital mix involves two types of risks:
1. Financial Risk
2. Non-Employment of Debt Capital
Risk (NEDC)