Capital structure and Leverage with problems

1. Capital Structure and
Leverage
Dr. Mangesh M. Bhople

2. Unit: 2 Capital Structure
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Capital Structure:
Meaning,
Factors affecting Capital Structure
Internal factors,
External factors
General factors

3. Meaning
The term `capital structure' represents the total
long-term investment in a business
firm.
It includes funds raised through :
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Reserves and Surplus,
Bonds / Debentures
Term loans from financial
institutions
Preference shares
Equity Shares
Debt
Sources
Equity/
Ownership
Sources

4. MIT ACSC, Alandi 4

5. Patterns of Capital Structure
1. Capital structure with equity shares only
2. Capital structure with equity and preference shares
3. Capital structure with equity shares and debentures
4. Capital structure with equity, preference shares and debentures
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6. Capital structure
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7. Capital Structure Planning
Decision regarding what type of capital structure a company
should have is of critical importance because of its
potential impact on profitability and solvency.
The small companies often do not plan their capital structure.
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8. Capital Structure Planning
The unplanned capital structure does not permit an economical use of
funds for the company.
A company should therefore plan its capital structure in such a way that
it derives maximum advantage out of it and is able to adjust more
easily to the changing conditions.
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9. Capital Structure Planning
• Theoretically, a company should plan an optimum capital structure in
such a way that the market value of its shares is maximum.
The value will be maximised when the marginal real cost of each
source of funds is the same.
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10. Understanding with Problem
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11. Class Activity
• Note the differences in the capital structures of the two companies
and find out the reasons for the differences.
• Source: www.moneycontrol.com
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12. Factors affecting Capital Structure
• Size of Company (I) -Small companies may have to rely on the founder’s money but as
they grow they will be eligible for long-term financing because larger companies are
considered less risky by investors.
• Nature of Business (I) -If your business is a monopoly you can go for debentures because
your sales can give you adequate profits to pay your debts easily or pay dividends.
• The Regularity of Earnings (I) -A firm with large and stable incomes may incur more
debt in its capital structure, unlike the one that is unstable.
• Conditions of the Money Markets (E)–Capital markets are always changing. You don’t
want to issues company shares during a bear market, you do it when there is a bull run.
• Government policy (E) – This is important to consider. A change in lending policy may
increase your cost of borrowing.
• Cost of Floating (E) – The cost of floating equity is much higher than that of floating debt.
This may influence the finance manager to take debt financing the cheaper option.
• Debt -Equity Ratio (I) / Leverage or Trading on equity– As stated debt is a liability
whose interest has to be paid irrespective of earnings. Equity, on the other hand, is
shareholders money and payment depend on profits being paid. However, debt is cheaper than
issuing shares. Debt interest has some tax deductions that is not the case for dividends paid to
equity holders.
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13. Leverage or Trading on Equity
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14. Leverage – Concept and meaning
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What do you think??

15. Leverage – Concept and meaning
In general terms, leverage means relationship between two interrelated variables.
While studying the concept of leverage, it is to be remembered that the two variables
are related to each other i.e., where one variable depends on the other variable.
The dependent variable is shown as a numerator whereas independent variable is
shown as a denominator.
In financial world, these variables can be cost and profit, sales and profit, EBIT-EPS,
etc.
Therefore, leverage may be defined as a % change in one variable (dependent)
divided by % change in another variable (independent).
Alternatively, it can be shown as
Leverage = % Change in Dependent Variable
-------------------------------------------
% Change in Independent Variable
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16. Types of Leverages
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17. Types of Leverages…..
Contribution
• Operating Leverage = ------------------
Contribution EBIT
Where, Contribution = Sales –
Variable Cost &
EBIT = Earnings before Interest and Tax
---------------
EBIT
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18. Types of Leverages…..
EBIT
• Financial Leverage = ----------------
EBT
Where, EBIT = Earnings before Interest and Tax &
EBT = Earning Before Tax
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19. Types of Leverages…..
Combined Leverage = O.L. * F.L
OR
Contribution EBIT Contribution
------------------ * -------- = -----------------
EBIT EBT EBT
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20. MIT ACSC, Alandi 20

21. Problem:
Statement of EBT
Particulars Amount in Rs.
Sales 90,00,000
Less: Variable Cost 20,00,000
Contribution 70,00,000
Less: Fixed Cost 5,00,000
EBIT 65,00,000
Less: Interest 2,00,000
EBT 63,00,000
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A firm has a sale of Rs. 90 lakh, variable cost of 20 lakh, fixed cost of Rs.
5,00,000.
The capital structure of the firm includes 10% debenture of Rs. 20 lakh and
equity share capital of Rs. 40 lakh.
Calculate operating, financing and combined leverage.

22. Statement of EBT
Particulars Amount in Rs.
Sales 90,00,000
Less: Variable Cost 20,00,000
Contribution 70,00,000
Less: Fixed Cost 5,00,000
EBIT 65,00,000
Less: Interest 2,00,000
EBT 63,00,000
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23. MIT ACSC, Alandi 23
April 2018

24. MIT ACSC, Alandi 24
October 18

25. MIT ACSC, Alandi 25
April 2019