This document discusses capital structure decision making. It summarizes that business risk exists prior to financing decisions, while financial risk is added through the use of debt. Together these risks determine total corporate risk. It then outlines various analytical tools for evaluating capital structures, including EBIT-EPS analysis, leverage analysis, cash flow analysis, and comparative analysis against industry averages. Guidelines are provided for capital structure planning and common policies used in practice.

1. CAPITAL STRUCTURE
DECISION

2. Business risk is the risk inherent in the operations of the firm,
prior to the financing decision. Thus, business risk is the
uncertainty inherent in a total risk sense, future operating
income, or earnings before interest and taxes (EBIT). Business
risk is caused by many factors. Two of the most important are
sales variability and operating leverage.
Financial risk is the risk added by the use of debt financing.
Debt financing increases the variability of earnings before
taxes (but after interest); thus, along with business risk, it
contributes to the uncertainty of net income and earnings per
share. Business risk plus financial risk equals total corporate
risk.

3. OUTLINE
..
•
• EBIT – EPS Analysis
• ROI – ROE Analysis
• Ratio Analysis
• Leverage Analysis
• Cash Flow Analysis
• Comparative Analysis
• Guidelines for Capital Structure Planning
• Capital Structure Policies in Practice

4. EBIT – EPS ANALYSIS
The relationship between EBIT and EPS is as follows:
(EBIT – I) (1 – t)
EPS = n

5. BREAK-EVEN EBIT LEVEL/POINT OF
INDIFFERENCE
There is a point of EBIT at which two Financing options
provide the same amount of EPS for shareholders. It can be
derived from the following equation:
(EBIT*-I1) (1-T) = (EBIT*-I2) (1-T)
n1 n2
If the level of EBIT for the point of indifference is relatively low and managers
are fairly confident of achieving that level, then the firm may decide to use an
increased level of leverage to maximize EPS, which in turn maximises
shareholders’ wealth. Otherwise it is advisable to decide the financing structure
in favour of equity.

6. ROI – ROE ANALYSIS
ROE = [ROI + (ROI – r) D/E] (1 – t)
where ROE = return on equity
ROI = return on investment
r = cost of debt
D/E = debt-equity ratio
t = tax rate

7. LEVERAGE ANALYSIS
• There are two kinds of leverage, viz., operating leverage and
financial leverage.
• Operating leverage arises from the firm’s fixed operating
costs. Rent Expenditure, Insurance expenditure, etc.
• Financial leverage arises from the firm’s fixed financing
costs. Interest on Debt

8. INCOME STATEMENT FORMAT
Sales
Operating Less: Variable costs
leverage Less: Fixed operating costs
Contribution before interest and tax
Less: Interest on debt Total
Profit before tax
leverage
Financial Less: Tax
leverage Profit after tax
Less: Preferred dividend
Equity earnings

9. CERTAIN RELATIONSHIPS
PBIT = Q (P – V) – F
PAT = (PBIT – I) ( 1 – T)
(PBIT – I) (1 – T) – Dp
EPS =
N
= [Q (P – V) – F – I] (1 – T) – Dp
N

10. OPERATING LEVERAGE
The sensitivity of profit before interest and taxes (PBIT) to
changes in unit sales is referred to as the degree of operating
leverage (DOL).
Δ PBIT/PBIT
DOL =
ΔQ/Q
Q (P – V) Contribution
= =
Q (P – V) – F Profit before interest
and tax

11. FINANCIAL LEVERAGE
The sensitivity of profit before tax (or profit after tax or earnings
per share) to changes in PBIT is referred to as the degree of
financial leverage.
DFL = Δ PBT / PBT = PBIT
Δ PBIT / PBIT PBIT – I
= Profit before interest and tax
Profit before tax

12. TOTAL LEVERAGE/Combined Leverage
The sensitivity of profit before tax (or profit after tax or earnings
per share) to changes in unit sales is referred to as the degree of
total (or combined) leverage (DTL).
DTL = Δ PBT / PBT = Q (P – V)
ΔQ/Q PBIT – T
Contribution
=
Profit before tax
DTL = DOL x DFL

13. Desirability of Financial Leverage
 Summery of Analysis of Financial Leverage
◦ Substitution of Equity with debt enhances earnings for equity
shareholders, as cheaper debt replaces more expensive equity.
◦ As the EPS for shareholders increases, the variability of EPS too
increases. In effect, this means that the shareholders are exposed
to greater risk as more and more debt substitutes for equity.
◦ It can be concluded that if the level of EBIT is not sufficiently
large, then it is beneficial to have less debt. The financing option
with a lower amount of debt provides higher earnings per share.

14. Capital Structure of firms
 If sales tend to fluctuate widely, then cash flows and the
ability to service fixed charges will also vary. Such a firm is
said to have high business risk. Consequently, there is a
relatively large risk that the firm will be unable to meet its
fixed charges, and interest payments are fixed charges. As
a result, firms in unstable industries tend to use less debt
than those whose sales are subject to only moderate
fluctuations.
 Public utilities place greater emphasis on long-term debt
because they have more stable sales and profits as well as
more fixed assets. Also, utilities have fixed assets which
can be pledged as collateral.

15. Cont…..
 Trade firms use retained earnings to a greater extent,
probably because these firms are generally smaller and,
hence, have less access to capital markets.
 Public utilities have lower retained earnings because they
have high dividend payout ratios and a set of stockholders
who want dividends.
 Any financial plan today involves predictions of the future
economic outlook. If these predictions can be made with a
high degree of confidence, the financial manager can use
debt funds in his/her operations with greater assurance. The
burdens of long-term debt can be assumed with greater
confidence because sales, costs, and profits are less
vulnerable to fluctuations. Therefore, the ability to meet
fixed financial obligations is more assured.

16. RATIO ANALYSIS
• Interest Coverage Ratio
Earnings before interest and taxes
Interest on debt
• Cash Flow Coverage Ratio
EBIT + Depreciation + Other non-cash charges
Interest on debt + loan repayment installment
(1 – Tax rate)

17. CASH FLOW ANALYSIS
The key question in assessing the debt capacity of a firm
is whether the probability of default associated with a
certain level of debt is acceptable to the management.
The cash flow analysis establishes the debt capacity by
examining the probability of default.

18. INVENTORY OF RESOURCES
It would be helpful to supplement cash flow analysis by
estimating potential sources of liquidity available to the firm to
meet possible cash drains. These sources, as suggested by
Gordon Donaldson, may be divided into three categories:
• Uncommitted reserves
• Reduction of planned outlays
• Liquidation of assets

19. COMPARATIVE ANALYSIS
• A common approach to analysing the capital structure of a
firm is to compare its debt-equity ratio to the average debt-
equity ratio of the industry to which the firm belongs.
• Since the firms in an industry may differ on factors like
operating risk, profitability, and tax status it makes sense to
control for differences in these variables.

20. GUIDELINES FOR CAPITAL
STRUCTURE PLANNING
• Avail of the tax advantage of debt
• Preserve flexibility
• Ensure that the total risk exposure is reasonable
• Examine the control implications of alternative financing
plans
• Subordinate financial policy to corporate strategy
• Mitigate potential agency costs

21. GUIDELINES FOR CAPITAL
STRUCTURE PLANNING
• Resort to timing judiciously
• Finance proactively not reactively
• Know the norms of lenders and credit rating agencies
• Issue innovative securities
• Widen the range of financing sources
• Communicate intelligently with investors

22. CAPITAL STRUCTURE POLICIES
Five common policies are:
A. No debt should be used
B. Debt should be employed to a very limited extent
C. The debt-equity ratio should be maintained around 1:1
D. The debt-equity ratio should be kept within 2:1
E. Debt should be tapped to the extent available