Capital Structure

CAPITAL STRUCTURE
INTRODUCTION
• The objective of a firm should be directed towards the maximization of the

firm‘s value.
• The proportion of funds contributed by different sources is termed as “Capital

Structure”. The decision about the proportion and type of financing with the
aim of wealth maximisation is the Financing decision.
• Thus managers aim to identify the optimal capital structure

INTRODUCTION
• Value of firm(EV) = EBIT

Overall cost of capital / weighted average cost of capital
• Capital structure will decide the weight of the debt & equity and ultimately the
overall cost of the capital as well as value of the firm
CAPITAL STRUCTURE DECISION
CAPITAL STRUCTURE PLANNING AND POLICY
• The capital structure should be planned generally, keeping in view the

interests of the equity shareholders and the financial requirements of a
company.
• While developing an appropriate capital structure for its company, the

financial manager should interalia aim at maximizing the long-term market
price per share.
SOURCES
Debt: The essence of debt is that Equity: Funds contributed by owners

you promise to repay. If you fail to with no promise of repayment.
make those payments, you lose
control of your business.
▪Residual Claim
• Fixed Claim ▪ Not Tax Deductible
• Tax Deductible ▪ Lowest Priority In Financial Trouble
• High Priority in Financial Trouble ▪ Infinite
• Fixed Maturity ▪ Management Control
• No Management Control
DEBT – COSTS & BENEFITS
Benefits Costs
▪ Tax Benefits: ▪ Agency Cost:
▪ you are allowed to deduct interest expenses from ▪ When you lend money to a business, you are allowing the
your income to arrive at taxable income. This stockholders to use that money in the course of running that
reduces your taxes. When you use equity, you are business. Stockholders interests are diﬀerent from your
not allowed to deduct payments to equity interests, because You (as lender) are interested in getting your
money back but Stockholders are interested in maximizing
their wealth. This leads to conflict of interest which has to be
▪ Discipline to Management: resolved at every action by BOD
▪ If you are managers of a firm with no debt, and you
generate high income and cash flows each year, you ▪ Loss of Flexibility:
tend to become complacent. The complacency can ▪ When a firm borrows up to its capacity, it loses the flexibility
lead to ineﬃciency and investing in poor projects. of financing future projects with debt
There is little or no cost borne by the managers.
Forcing such a firm to borrow money can be an ▪ Bankruptcy Cost :
antidote to the complacency. ▪ The probability of bankruptcy depends on uncertainty of future
cashflows and indirect costs arising because people perceive
you to be in financial trouble
FRAMEWORK FOR CAPITAL STRUCTURE: THE
FRICT ANALYSIS
• Flexibility
• Risk
• Income
• Control
• Timing
FACTORS AFFECTING CAPITAL STRUCTURE
• Company Profile: Size , Nature • Tax rate

• Amount of finance & period • Business Risk & Financial Risk
• Purpose of finance • Control
• Cash Flow amount & consistency • Issue Costs
• Availability of funds • Regulatory framework
• Assets: Tangible & Intangible • Loan Covenants
• Interest Coverage Ratio & Debt Service • Stock price level
Coverage Ratio
• Expected Return
• Expected Growth rate
• Cost of financing
CAPITAL STRUCTURE THEORIES
• Trading on Equity Theory

• Pecking order theory
• Static Trade Off Theory
TRADING ON EQUITY
Trading on equity is the use of debt by corporations to increase their earnings on common
stock.
They use fixed financial obligation instruments such as bonds, other debt, and preferred
stock for the purpose.
Example, consider this: in order to earn more than the interest on the debt, a corporation
may consider using long-term debt to purchase assets. This earning which is in excess of
the interest expense on the new debt will increase the earnings of the corporation's
stockholders. This increase in earnings is an indication that the corporation successfully
carried out trading on equity. However, if the newly purchased assets earn less than the
interest expense on the new debt, the earnings of stockholders will decrease. This is an
indication that the corporation was unsuccessful in carrying out trading on equity.
Trading on equity is also sometimes referred to as financial leverage or the leverage factor.
PECKING ORDER THEORY
• The―pecking order theory is based on the assertion that managers have more
information about their firms than investors. This disparity of information is referred to
as asymmetric information.
• The manner in which managers raise capital gives a signal of their belief in their firm‘s
prospects to investors.
• This also implies that firms always use internal finance when available, and choose
debt over new issue of equity when external financing is required.
• The pecking order theory is able to explain the negative inverse relationship between
profitability and debt ratio within an industry.
• However, it does not fully explain the capital structure differences between industries.
STATIC TRADE OFF THEORY
This theory suggests that firms trade-off tax shields and bankruptcy costs and
move towards an optimal debt ratio. That is, they stop borrowing when the present
value of bankruptcy costs exceeds the present value of tax shields.
In other words, profitable firms that can avail tax shields will borrow relatively
more than less profitable firms. But some academic studies conducted in the US and
elsewhere do not support this hypothesis. Profitable firms, on the contrary, borrow
less. Other studies have found positive relation between taxes and financing
decisions.
EVALUATION OF CAPITAL STRUCTURE
• EBIT-EPS Analysis (also MPS)

• Indifference point
• Financial Break Even point
• Financial Ratios (DSCR & ISCR)
• WACC (Module V)
• Leverage (Module VI)
EBIT-EPS ANALYSIS
• The EBIT-EPS analysis is a first step in deciding about a firm‘s capital structure.
• It suffers from certain limitations and does not provide unambiguous guide in determining
the level of debt in practice.
• The major short comings of the EPS as a financing-decision criterion are:
a)It is based on arbitrary accounting assumptions and does not reflect the economic profits.
b)It does not consider the time value of money.
c)It ignores the variability about the expected value of EPS, and hence, ignores risk.
d)Designing an appropriate capital structure is concerned with choosing a capital structure
that can provide the highest wealth, i.e., the highest MPS (Market Price Per Share). This,
in turn, is dependent upon EPS.
INDIFFERENCE POINT
• Finance managers often evaluate financing plans based on how the plan affects earnings per share, or
EPS. Financing plans produce different levels of EPS at different levels of earnings before interest and
taxes, or EBIT. The EBIT-EPS indifference point is the EBIT level at which the earnings per share is equal
under two different financing plans.
• The indifference level of EBIT is one at which the EPS remains same irrespective of the debt equity mix.
While designing a capital structure, a firm may evaluate the effect of different financial plans on the level
of EPS, for a given level of EBIT.
• Indifferent point/level is that EBIT level at which the Earnings Per Share (EPS) is the same for two
alternative financial plans. The indifferent point can be defined as "the level of EBIT beyond which the
benefits of financial leverage begin to operate with respect to Earnings Per share (EPS)".
INDIFFERENCE POINT
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
PD1 = Preference Dividend in alternative financial plan 1.
PD2= Preference Dividend in alternative financial plan 2.
N1= Number of equity shares under alternative financial plan 1.
N2 = Number of equity shares under alternative financial plan 2.
INDIFFERENCE POINT
The point of indifference can also be

determined by preparing the EBIT chart
or range of earnings chart. This chart
shows the expected earnings per share
(EPS) at various levels of earnings
before interest and tax (EBIT) which
may be plotted on a graph and straight
line representing the EPS at various
levels of EBIT may be drawn. The point
where this line intersects is known as
point of indifference or break-even
point.
FINANCIAL BREAK EVEN POINT
• In case the EBIT level of a firm is just sufficient to cover the fixed financial charges then such level of
EBIT is known as financial break-even level.
• The financial break-even level of EBIT may be calculated as follows:
• If the firm has employed debt only (and no preference shares), the financial break-even EBIT level is
• Financial break-even EBIT = Interest Charge
• If the firm has employed debt as well as preference share capital, then its financial break-even EBIT
will be determined not only by the interest charge but also by the fixed preference dividend. It may
be noted that the preference divided is payable only out of profit after tax, whereas the financial
break-even level is before tax. The financial break-even level in such a case may be determined as
follows:
• Financial break-even EBIT =
DEBT SERVICE COVERAGE RATIO
• Benchmark to measure the cash-producing ability of entity to cover debt

payments
• DSCR= Cash operating Profit (EBITDA)
Principal & Interest paid
• A DSCR below one indicates inability to repay debt.
• Widely used by banks
INTEREST SERVICE COVERAGE RATIO
• Tool for financial institutions
• ISCR less than one suggests the inability to serve its interest on debts
• It explains the ability to earn operating profit to meet interest payment of the loan
ISCR = Net operating Income (EBIT)
Interest paid
• Sometimes, it is also calculated as
ISCR = Cash operating Profit (EBITDA)
Interest paid
It explains the ability of cash profits to meet interest payment of the loan

Capital Structure

Uploaded by

Copyright:

Available Formats

Capital Structure

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Capital Structure

Uploaded by

Copyright:

Available Formats

CAPITAL STRUCTURE

• The objective of a firm should be directed towards the maximization of the

• The proportion of funds contributed by different sources is termed as “Capital

• Thus managers aim to identify the optimal capital structure

• Value of firm(EV) = EBIT

• The capital structure should be planned generally, keeping in view the

• While developing an appropriate capital structure for its company, the

Debt: The essence of debt is that Equity: Funds contributed by owners

• Company Profile: Size , Nature • Tax rate

• Trading on Equity Theory

• EBIT-EPS Analysis (also MPS)

The point of indifference can also be

• Benchmark to measure the cash-producing ability of entity to cover debt

You might also like