The document defines capital structure as the permanent long-term financing of a company, including long-term debt, common stock, preferred stock, and retained earnings. It discusses the concept of optimal capital structure, which minimizes a firm's cost of capital. The document also outlines various approaches to establishing capital structure, including EBIT-EPS analysis and cash flow analysis. It evaluates capital structure based on factors like flexibility, risk, return, and control.

1. Capital Structure
By:Akhil Sarda
Vishwak Kasturi
Ashwin
Disha
Prabhas
Chitrasen
Shabya

2. Contents
• Definition
• Concept of Optimal Capital Structure
• Significance of Capital Structure
• Features of Appropriate Capital Structure
• Elements of Capital Structure
• Determinants of Capital Structure
• Approaches to establish Capital Structure
• Evaluation of Capital Structure

3. DEFINITION
• The permanent long-term financing of a company
including long term debt, common stock and
preferred stock and retained earnings. Its is different
from financial structure which includes short term
debt and accounts payable.
• Debt comes in the form of bond issues or long-term
notes payable, whereas equity is classified as
common stock, preferred stock, or retained earnings.
• The capital structure is the firm's various sources of
funds used to finance its overall operations and
growth.
• The capital structure of a business enterprise should
be ideal , that is according to the requirement of the
business enterprise.

4. Capital
Structure
What is “Capital Structure”?
Balance Sheet
Current Current
Assets Liabilities
Debt
Fixed Preference
Assets hares
Ordinary
shares

5. For Example
A company has equity shares of RS. 5,00,000 and
reserves and surplus RS. 2,00,000 and Debentures of
RS. 3,00,000. The total long term capital or
capitalization is RS. 10,00,000.and the capital structure
of the firm or the mix of capitalization consists equity ,
retained earnings and debentures.

6. Concept of optimal capital
structure
• The capital structure that minimizes the firm's cost of
capital and thereby maximizes the value of the firm.
• The optimal capital structure is obtained when the
market value per share is at maximum or the
average cost is minimum.
• The determination of capital structure is formidable
task because a no. of factors influence the capital
structure of the company.

7. Significance of capital structure
• It is concerned with the formulation and designing of
proper capital structure .
• The most important decision of any company is
involved in the formulation of an appropriate capital
structure.
• Capital structure will maximize the earning per share
of shareholders.
• The design of the capital structure of a company has
some bearing on the profitability and influence on the
risk and return of the shareholders.

8. • A conservative policy may deprive the firm of its
benefits in terms of magnifying the rate of return of
its equity shareholder.
• This is concerned with the determination of debt-
equity combination.
• If capital structure is appropriate it may improve the
and solvency position of the company.

9. Features of capital structure
• The cost of capital should be minimum.
• The debt should be in limits.
• It should be flexible and adoptable.
• It should not dilute the control of the company.

10. ELEMENTS OF CAPITAL
STRUCTURE
• Debt-Equity Mix:
Firms should establish a standard debt- equity
ratio for their capital structure.
• Terms and conditions:
Interest payments may be based on fixed or
floating rates of interest. It should also keep in view the
terms and conditions laid down in the loan agreements
or debt instruments.

11. • Priority and Maturity:
Securities differ in case of maturities and also
priority of payments.
• Currency:
In recent times, companies are allowed to
mobilize funds from overseas markets .
• Financial Innovations:
Innovation has made the securities more
attractive to investors and reduces cost of capital to the
company.
• Financial market segments:
Financial markets have different segments.

12. Determinants of Capital
Structure
• The degree of business risk :- Companies
experiencing variation in their net operating income
rely more on equity than debt and others with stable
earnings add more debt.
• Control :- For retaining control, companies should
avoid the issue of new equity shares.
• Capital Market Condition:- Capital market condition
influence the capital structure of a company.

13. • Government Regulations :- Government regulations
influence the financing pattern of a company through
legislation.
• Attitude Towards Risk : The attitude of
management towards risks plays a vital role in
shaping the capital structure plan.
• Cost Of Capital :- It is a important factor which
formulate the capital structure.

14. • Flexibility : The capital structure must be flexible
and have debt reserve capacity.
• Size Of The Company :- Influences the availability
of funds from different sources.
• Trading On Equity :- Financial leverage effects on
EPS, is one of the important factor in capital
structure planning. High leverage results in high EPS
and vice versa.

15. APPROACHES TO ESTABLISH
TARGET CAPITAL STRUCTURE
EBIT-EPS approach: for analyzing the impact of debt on
EPS
Valuation approach: for determining the impact of debt
on the share holders value
Cash flow approach: for analyzing the firm’s ability to
service debt

16. EBIT-EPS ANALYSIS
• It 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 break-even level of EBIT for alternative
financial plans.

17. 17
Effect of Financial Plan on EPS :
Constant EBIT
Q.1. Suppose a firm is unlevered consisting
of 1 lacs ordinary shares of Rs. 10 each.
The firm wants to raise Rs. 2,50,000 to
finance its investments and is considering
two alternative methods of financing:
a. To issue 25,000 ordinary shares at
Rs. 10 each
b. To borrow Rs. 2,50,000 at 8%
interest rate.
If the firms earnings before
interest and taxes after additional
investment are Rs. 3,12,500 and
the tax rate is 50%. What is the
effect of alternatives on EPS?
Financial Plan
Debt-equity
(Rs)
All-equity
(Rs)
1. Earnings before interest and taxes,
EBIT
312500 312500
2. Less: interest, INT 20000 0
3. Profit before taxes, PBT = EBIT –
INT
292500 312500
4. Less: Taxes, T (EBIT – INT) 146250 156250
5. Profit after taxes, PAT = (EBIT –
INT) (1 – T)
146250 156250
6.Less:preference dividend 0 0
7.Earning available to ordinary
shareholders
146250 156250
8.Shares outstanding 100000 125000
9. EPS 1.46 1.25

18. VALUATION APPROACH
• Determines the impact of debt on the shareholders
value
• High debt increases the cost of financial distress &
agency cost
• Trade off between tax shield and cost of financial
distress & agency cost
• Firm should employ debt to the point the marginal
benefits & costs are equal

19. WHAT IS CASH FLOW
Business
Cash In
Customers
Products / Services
Cash out
Payroll
Inventory
Utilities
Rent
Taxes
Interests
Loans
Etc.
Equity and/or
Debt financing

20. CASH FLOW ANALYSIS
• In determining a firm’s target capital structure, a key
issue is the firm’s ability to service its debt.
• The focus of this analysis is also on the risk of cash
insolvency-the probability of running out of the cash
given a particular amount of debt in the capital
structure
• This analysis is based on a through cash flow analysis
and not on rules of thumb based on various coverage
ratios

21. Components of cash flows:
• This type of analysis is done through the
preparation of proforma cash flow statements.
• It is grouped into three kinds.
• Operating cash flows:
It is generated from the main operations of the
business and determined from the projected financial
statements.
• Non-operating cash flows:
Normally capital expenditure and working
capital changes included.
• Financial flows:
Payment of interest and dividends and
repayment of debt, lease rentals and other financial
charges are included.

22. EVALUATION OF CAPTIAL
STRUCTURE:
• Capital structure is evaluated from different
points of view.
• In the view of shareholders’ return, risk and value
are most important.
• From the strategic point of view, flexibility is
important.
• A sound capital structure must posses all these
factors.

23. The main consideration are
follows:
• Flexibility
The debt–equity mix should be within the debt
capacity. In other words the capital structure should be
flexible.
• Risk
Usage of more debt adds to the profitability of the
shareholders. It also adds financial risk to the company.
• Return
The objective of the capital structure is to minimize
the cost and maximize the market value of the shares.

24. • Control
The capital structure should not result in parting
with the control of the company.
• Timing
While designing a capital structure, the current and
future capital market condition should be taken into account.

25. Particulars Plan 1 Plan 2 Plan 3 Plan 4 Plan 5
EBIT
Less-Interest
Net Income(NI)
Ke
Value of Equity(S)
Value of Debt(D)
V(S+D)
Ko(EBIT/V)*100
450000
45000
405000
.12
3375000
450000
3825000
11.76
450000
60000
390000
.125
3120000
600000
3720000
12.10
450000
82500
367500
.135
2722222
750000
3472222
12.95
450000
108000
342000
.15
2280000
900000
3180000
14.15
450000
147000
303000
.18
1683333
1050000
2733333
16.46

26. Bibliography
• I. M.Pandey