Notes

1. Capital structure Planning

2. Important Issues in Capital Structure Planning
The following questions need to be addressed:
• How should the investment project be financed?
• How does financing affect shareholders’ risk, return and value?
• Does there exist an optimum financing mix in terms of maximum
value to the firm’s shareholders?
• Can the optimum financing mix be determined in practice for a
company?
• What factors in practice should a company consider in designing its
financial policy?

3. Leverage Analysis
• It refers to analysis of relationship between 2 interrelated variables
• It analyses the responsiveness of one financial variable to another
• Firms’ profits are affected by Operating Leverage and Financial
Leverage
• Operating Leverage affects a firm’s operating profits/net operating
income (EBIT) whereas Financial Leverage affects PAT or EPS

4. Operating and Financial Risk
Operating Risk:
• It can be defined as the variability of EBIT (Return on Assets)
• The internal and external environment in which a firm operates, determines the variability
of EBIT
• The variability of EBIT is comprised of variability of sales and variability of expenses
Financial Risk:
• It refers to variability in EPS
• It is associated with usage of debt in capital structure
• Firms exposed to same degree of operating risk can differ with respect to financial risk
when they finance their assets differently
Riskiness of EBIT and EPS is measured using standard deviation and coefficient of
variation

5. Degree of Operating Leverage (DOL)
Can be computed as;
= % Change in EBIT / % Change in Sales
OL is also defined as the ability of a firm to magnify the effect of change in sales over the level of
EBIT.
At a particular sales volume, it can be defined as:
 Contribution/EBIT
= 1+(Fixed Cost/EBIT)
The presence of fixed cost leads to Operating Leverage
DOL is 1 in absence of any fixed cost
Introduction of Fixed Cost magnifies operating profits at higher levels of operations
DOL is Positive (Negative) when the firm is operating above (below) the Breakeven level
Break Even Level: Level of Sales just sufficient to cover its variable and fixed costs

6. Degree of Operating Leverage (DOL)
Situation Present Expected
No. of units sold 1000 1400
Sales (SP = Rs. 10 P.U.) 10000 14000
Less: Variable Cost (V.C. = Rs. 7 P.U.) -7000 -9800
Contribution 3000 4200
Less: Fixed Cost -1000 -1000
EBIT 2000 3200
 In this situation, sales change by 40%, and EBIT
changes by 60%.
i.e. OL = 1.5; i.e. for every 1% change in sales,
EBIT will change by 1.5%
 Whenever, the % change in EBIT resulting from
given % change in sales is greater than % change
in sales, the OL exists; and the relationship is
known as Degree of Operating Leverage (DOL).
As long as DOL is greater than 1, there is an
operating leverage.
 OL emerges as a result of fixed costs. If there are
no fixed costs, the change in EBIT is directly
proportional to the change in sales level. Higher
the level of fixed costs in relation to variable costs,
greater would be the DOL.

7. Significance of OL
­ The introduction of fixed costs into the cost structure of the firm tends to magnify the operating profits at
higher level of operations. This is due to the incremental contribution provided by each additional unit.
­ Depending on the proportion of fixed and variable costs in the cost structure, the incremental contribution
can lead to magnifying the operating profits. Once fixed costs are recovered by contribution, profits grow
proportionately faster than the growth in volume.
­ However, the same effect holds for decreasing sales volume also.
­ Analysis of OL of a firm is extremely useful to the firm, as it indicates the impact of change in sales on the
level of operating profits of the firm.
­ High DOL indicates high operating risk. A firm with high DOL can experience a magnified effect on EBIT
for small change in sales level, which works in the positive as well as negative direction.
­ Thus, a firm should try to avoid operating under high DOL. However, it must operate at levels sufficiently
higher than the break-even level.

8. Degree of Financial Leverage (DFL)
 Can be computed as;
= % Change in EPS / % Change in EBIT
= EBIT/PBT
= 1+(Interest/PBT)
= EBIT (1-t)/PBT (1-t)-PD; in presence of Preference Dividends (PD)
 The presence of fixed financial charge leads to Financial Leverage
 DFL is 1 in absence of any fixed financial charge
 DFL is Positive (Negative) when the firm is operating at a level above (below) the Financial Break Even level
Financial Break Even Level: Level of EBIT just sufficient to cover fixed financial
charges. At this level, EPS=0.
EBIT= Int.
or
EBIT= Int. + PD/(1-t)

9. Degree of Financial Leverage (DFL)
Situation Present Expected
EBIT 2000 3200
Less: Interest NIL NIL
Less: Tax (@30%) -600 -960
PAT 1400 2240
No. of outstanding shares 700 700
EPS 2 3.2
 In the above situation, the % change in EBIT and EPS is the same (60%), as there are no fixed financial charges

10. Degree of Financial Leverage (DFL)
Situation Present Expected
EBIT 2000 3200
Less: Interest -200 -200
Less: Tax -540 -900
PAT 1260 2100
No. of outstanding shares 700 700
EPS 1.8 3
 In this situation, the EPS changes by 66.67% for
60% change in EBIT; i.e. FL = 1.11. For every
1% change in EBIT, EPS will change by 1.11%
 Thus, the FL arises as a result of fixed financial
charges in the firm’s capital structure.
 The surplus generated by debt financing is
available to shareholders. Thus, the earnings
available to shareholders are enhanced.
 The existence of fixed financing charge is
instrumental to bring this magnifying effect and
also determines the extent of this effect.
 A higher level of fixed financial charge would
lead to a higher FL

11. Significance of FL
- Analysis of FL is one of the most important tools in the hands of the financial manager
- The advantage of raising money through borrowed funds with fixed financial charges accrues to equity
shareholders. When these funds are invested in opportunities offering higher return than the interest paid, the
benefit is accrued to equity shareholders.
- A company should follow prudent debt management policy and borrow accordingly.
- Employing debt financing, also exposes a firm to financial risk. Thus, a financial manager is required to
trade off between risk and return.
- If the EBIT declines, there will be a greater chance of financial insolvency.

12. Measures of Financial Leverage
Debt Ratio: D/D+E
This measures the debt to total capital, and can range between 0-1
Debt-Equity Ratio: D/E
This is used more popularly in practice. Its value can range from 0 to any large number
The above 2 ratios can be expressed either in terms of book values or market values. However,
using market value is theoretically more appropriate as it reflects the current attitude of investors
Interest Coverage Ratio: EBIT/Interest
This indicates the capacity of the company to meet fixed financial charges with
Net Operating Income (EBIT)
The use of fixed-charges sources of funds along with owners’ equity in the capital structure, is
described as financial leverage or gearing or trading on equity

13. Degree of Combined Leverage (DCL)
• DOL and DFL are combined to see the impact of total leverage on EPS
Can be computed as;
= % Change in EPS / % Change in Sales
= Contribution/PBT
Question: A firm has sales of Rs.1,000,000; Contribution margin of 30% and fixed costs of Rs.
150,000. It has debt of Rs. 800,000 at 10% interest rate. What are the operating, financial and
combined leverages? If the firm wants to double its EBIT, how much rise in sales would be needed
on a percentage basis?
Question: A firm has Sales of Rs. 8,000 million. Variable Costs are 70% of sales and it incurs fixed
cost of Rs. 450 million. It pays interest of Rs. 1,000 million on debt and is subject to tax rate of 30%.
Calculate different types of leverage. Estimate the percentage change in EPS if sales increase by 5%?
Question: A firm has interest liability of Rs. 20,000 and preference dividend of Rs. 36,000. Given the
tax rate of 30%, find out the financial break even level.

14. EBIT-EPS Analysis
 With leverage analysis, we analysed the relationship between change in sales level and EPS
 Under EBIT-EPS analysis, we analyse the impact of different patterns of financing on EPS
 With a particular level of EBIT, we analyse the level of return available to shareholders under different
conditions of financing
 Question: A company expects an EBIT of Rs.150,000 P.A. on an investment of Rs. 500,000. It has 4 options to
raise required funds:
1. Issue Equity (Shares of Rs. 100 each)
2. Raise 50% funds by Equity and 50% funds by 12% Preference Shares
3. Raise 50% funds by Equity, 25% by 12% Preference Shares and 25% by
10% Debt
4. Raise 25% funds by Equity, 25% by 12% Preference Shares and 50% by
10% Debt
Analyse the impact of different financial plans on EPS, assuming that the firm is subject to tax rate
of 50%

15. Plans 1 2 3 4
Equity Share Capital 500,000 250,000 250,000 125,000
Preference Capital - 250,000 125,000 125,000
Debt - - 125,000 250,000
Total Funds 500,000 500,000 500,000 500,000
EBIT 150,000 150,000 150,000 150,000
(Interest) - - (12,500) (25,000)
PBT 150,000 150,000 137,500 125,000
(Tax) (75,000) (75,000) (68,750) (62,500)
PAT 75,000 75,000 68,750 62,500
(Preference Dividend) - (30,000) (15,000) (15,000)
Profit available for Equity
Share Holders)
75,000 45,000 53,750 47,500
No. of outstanding shares
(Of Rs. 100 each)
5,000 2,500 2,500 1,250
EPS 15 18 21.5 38 (Maximum)

16. Favourable and Unfavourable Financial Leverage
 Financial Leverage is a twin-edged sword, and is favourable only when Return on Investment (ROI) > Cost of Debt
 In the previous example, ROI was 30% (150,000/500,000). If ROI is 18%, then EBIT = 500,000*18% (90,000)
 Its impact on the previous example is shown in the following table;
Plans 1 2 3 4
EBIT 90,000 90,000 90,000 90,000
(Interest) - - (12,500) (25,000)
PBT 90,000 90,000 77,500 65,000
(Tax) (45,000) (45,000) (38,750) (32,500)
PAT 45,000 45,000 38,750 32,500
(Preference Dividend) - (30,000) (15,000) (15,000)
Profit available for Equity
Share Holders)
45,000 15,000 23,750 17,500
No. of outstanding shares
(Of Rs. 100 each)
5,000 2,500 2,500 1,250
EPS 9 6 (Firm is earning 9% post
tax but paying 12% to
Preference shareholders)
9.5 (Firm is earning 9%
post tax but paying 5% post
tax to Debt Holders)
14 (Maximum)
(Firm is earning 9% post
tax but paying 12% and 5%
post tax to Preference
Shareholders and Debt
Holders respectively)

17. EBIT-EPS Analysis
(With Varying Patterns of EBIT)
Question: There are 3 firms A,B,C that are alike in all respects except for leverage.
The ROI earned by them depends on economic conditions. In normal conditions,
they earn 8%, and it may fluctuate to +/- 3% in good and bad conditions
respectively. Analyse the impact of varying financing patterns of these firms on
EPS, assuming the firm is subject to a tax rate of 50%. The following table
describes their capital structure;
Firms A B C
Equity Share Capital
(Shares of Rs. 100
each)
200,000 100,000 50,000
6% Debt - 100,000 150,000
Total 200,000 200,000 200,000

18. Analysis for Firm A
(With no Financial Leverage)
Economic Conditions Bad Normal Good
Total Assets 200,000 200,000 200,000
EBIT (Total Assets * ROI) 200,000 * 5% = 10,000 200,000 * 8% = 16,000 200,000 * 11% = 22,000
Interest - - -
PBT 10,000 16,000 22,000
Tax (5,000) (8,000) (11,000)
PAT 5,000 8,000 11,000
Number of shares
outstanding
2,000 2,000 2,000
EPS 2.5 4 5.5
There is no magnifying effect of increase in EBIT on EPS.
% change in EPS (+/-37.5%) is the same as % change in EBIT (+/-37.5%)

19. Analysis for Firm B
(With 50% Debt)
Economic Conditions Bad Normal Good
Total Assets 200,000 200,000 200,000
EBIT (Total Assets * ROI) 200,000 * 5% = 10,000 200,000 * 8% = 16,000 200,000 * 11% = 22,000
Interest (6,000) (6,000) (6,000)
PBT 4,000 10,000 16,000
Tax (2,000) (5,000) (8,000)
PAT 2,000 5,000 8,000
Number of shares
outstanding
1,000 1,000 1,000
EPS 2 5 8
There is a magnifying effect of increase in EBIT on EPS.
% change in EPS (+/-60%) is more than % change in EBIT (+/-37.5%)

20. Analysis for Firm C
(With 75% Debt)
Economic Conditions Bad Normal Good
Total Assets 200,000 200,000 200,000
EBIT (Total Assets * ROI) 200,000 * 5% = 10,000 200,000 * 8% = 16,000 200,000 * 11% = 22,000
Interest (9,000) (9,000) (9,000)
PBT 1,000 7,000 13,000
Tax (500) (3,500) (6,500)
PAT 500 3,500 6,500
Number of shares
outstanding
500 500 500
EPS 1 7 13
There is a magnifying effect of increase in EBIT on EPS.
% change in EPS (+/-85.7%) is more than % change in EBIT (+/-37.5%)

21. Indifference Point/Level
It refers to the level of EBIT at which the EPS remains constant, irrespective of
different financial plans
At this level, the firm is indifferent amongst different financing patterns
Indifference level of EBIT is computed using the following formula;
[ (EBIT-Interest1)(1-t)-PD1]/N1 = [ (EBIT-Interest2)(1-t)-PD2]/N2
Where; N1 and N2 are no. of outstanding shares under different
financing plans
(The above equation is a generalised formula where the firm is
comparing 2 alternate plans with different levels of debt and
preference capital)

22. Question: A company has an existing capital structure of 1,000,000
equity shares of Rs. 10 each. It is subject to a tax rate of 50% and
plans to raise additional capital of Rs.10,000,000 for a project. Its
evaluating 2 alternative financial plans:
A: Issue 1,000,000 equity shares of Rs. 10 each
B: Issue Rs. 10,000,000 debt carrying 14% interest rate
Compute the indifference point
Solution: EBIT = Rs. 2,800,000
1000000 2000000 2800000 3000000 4000000
-0.5
0
0.5
1
1.5
Indifference Level
Plan A Plan B
EBIT
EPS