The Firm's Capital Structure

Capital Structure is one of the most complex areas of Financial decision making because of its i
Types of Capital
Balance Sheet
Current Liabilities
Debt Capital
Long-term debt
Stockholder's equity Total Capital
Assets Preferred Stock
Common Stock Equity Equity Capital
Common Stock
Retained Earnings

The cost of debt is lower than the cost of other forms of financing. Lenders demand relatively lower
return because they take the least risk of any other long-term contributors of capital. (a) Thay have a
higher priority of claim against any earnings or assets available for payment. (b) They can exert far
greater legal pressure against the company to amke payment than can owners of preferred or common
stock. (c) The tax deductibility of interest payments lowers the debt cost to the firm substantially.
Whereas, equity capital is expected to remain in the firm for an indefinite period of time. The two basic
sources of equity capital are (1) Preferred stock and (2) Common Stock Equity, which includes common
stock and retained earnings. Common stock is typically the most expensive form of equity, followed by
retained earnings and then preferred stock. Because of equity's secondary position relative to debt,
suppliers of equity capital take greater risk than suppliers of debt capital and therefore must be
compensated with higher expected returns.

External Assessment of Capital Structure

The amount of leverage in the firm's capital structure can affect its value by affecting return and
risk. The level of debt (financial leverage) that is acceptable for one industry or line of business
can be highly risky in another, because different industries and lines of business have different
operating characteristics.

Probability of Bankruptcy
The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due depends
level of both business risk and financial risk. Business Risk:- It is the risk to the firm of being unable to cover its ope
general, the greater the firm's operating leverage- the use of fixed opearting costs-the higher its business risk. Other tw
Revenue stability and Cost stability also effect. Revenue stability- reflects the relative variability of the firm's sale
Firms with reasonably stable levels of demands and with products that have stable prices have stable revenues. The re
level of business risk. Firms with highly volatile product demand and prices have unstable revenues that result in high
business risk. Cost stability- reflects the relative predictability of input prices such as those for labor and materials. T
predictable and stable these input prices are, the lower the business risk; the less predictable and stable they are, the h
business risk. Business Risk varies among firms, regardless of their lines of business, and is not affected by capital str
decisions. The higher the firm's business risk, the more cautious the firm must be in establishing the capital structure.
high business risk therefore tend toward less highly leveraged capital structures (Agriculture, Cement, Retailing) and
business risk tend toward more highly leveraged capital structures (Utility sector, Service sector).
level of business risk. Firms with highly volatile product demand and prices have unstable revenues that result in high
business risk. Cost stability- reflects the relative predictability of input prices such as those for labor and materials. T
predictable and stable these input prices are, the lower the business risk; the less predictable and stable they are, the h
business risk. Business Risk varies among firms, regardless of their lines of business, and is not affected by capital str
decisions. The higher the firm's business risk, the more cautious the firm must be in establishing the capital structure.
high business risk therefore tend toward less highly leveraged capital structures (Agriculture, Cement, Retailing) and
business risk tend toward more highly leveraged capital structures (Utility sector, Service sector).

Financial Risk:- The firm's capital structure directly affects its financial risk, which is the risk to the firm of being un
required financial obligations. The penalty for not meeting financial obligations is bankruptcy. The more fixed-cost fi
and preferred stock a firm has in its capital structure, the greater its financial leverage and risk. The total risk of a firm
and financial risk combined determines its probability of bankruptcy.
aking because of its interrelationship with other financial decision variables.

hey come due depends largely on its

unable to cover its operating costs. In
business risk. Other two factors:-
bility of the firm's sales revenues.
table revenues. The result is low
nues that result in high levels of
labor and materials. The more
d stable they are, the higher the
affected by capital structure
g the capital structure. Firms with
ement, Retailing) and firms with low
r).
 o the firm of being unable to cover
The more fixed-cost financing debt
The total risk of a firm-business risk
 Example
Cooke Company, a soft drink manufacturer, is preparing to make a capital structure decision. It has obtaine
forecasting group: There is a 25% chance that sales will total Rs 4,00, 000; a 50% chance that sales will tota
000 and variable operating costs equal 50% of sales.

Cooke Company's Current Capital Structure

Particulars Amount
Long-term debt 0
Common stock equity (25, 000 shares
@Rs. 20) 500000
Total capital (assets) 500000

Table 1
Sales and Associated EBIT calculations for Cooke Company (Rs. 000)
Particulars
Probability of Sales 0.25 0.5
Sales Revenue 400 600
Less: Variable operating costs (50% of
sales) 200 300

Less: Fixed operating costs 200 200

EBIT 0 100

Table - 2
capital structures associated with alternative debt ratio for cooke company(rs.
Capital structure (rs. 000)
Debt Ratio Total Assets Debt
0% 500 0
10% 500 50
20% 500 100
30% 500 150
40% 500 200
50% 500 250
60% 500 300
Table - 3
Level of debt, interest rate, Rupee Amount of annual Interest associated with cooke companys alter
Interest rate on all debt
Capital Stucture Debt Ratio Debt
(%)
0% 0 0%
10% 50 9%
20% 100 9.5%
30% 150 10%
40% 200 11%
 50% 250 13.5%
60% 300 16.5%

calculation of EPS for Debt Ratios (000) for cooke company

Case 1: when the debt ratio is 0%
Particulars
profitability of EBIT 0.25 0.5
EBIT 0 100
Less: interest (table 3 refer) 0 0
EBT/Net profit before taxes 0 100
less: taxes (40%) 0 40
EAT/ Net Profit after Taxes/ EAC
(Earnings Available to common stock 0 60
holders)
common stock outstsanding ( Table 2
refer) 25 25

EPS 0 2.4
Expected EPS 2.4
Standard deviation of EPS* 1.7
Co- efficient of Variation of EPS
( standard deviation of EPS/expected 0.71
EPS)

Standard deviation of EPS*

EPS EPS-Exp EPS (EPS - Exp EPS)^2

0 -2.4 5.76
2.4 0 0
4.8 2.4 5.76
Exp EPS 2.4

Case 2: when the debt ratio is 10%

Particulars
profitability of EBIT 0.25 0.5
EBIT 0 100
Less: interest (table 3 refer) 4.5 4.5
EBT/Net profit before taxes -4.5 95.5
less: taxes (40%) -1.8 38.2

EAT/ Net Profit after Taxes/ EAC

(Earnings Available to common stock -2.7 57.3
holders)
common stock outstsanding ( Table 2 22.5 22.5
refer)
 EPS -0.12 2.5
Expected EPS 2.55
Standard deviation of EPS* 1.90

Co- efficient of Variation of EPS

( standard deviation of EPS/expected 0.75
EPS)

Standard deviation of EPS*

EPS EPS-Exp EPS (EPS - Exp EPS)^2

-0.12 -2.6 7.0

2.5 -0.03 0.0
5.2 2.67 7.1
Exp EPS 2.53

Case 3: when the debt ratio is 20%

Particulars
profitability of EBIT 0.25 0.5
EBIT 0 100
Less: interest (table 3 refer) 9.5 9.5
EBT/Net profit before taxes -9.5 90.5
less: taxes (40%) -3.8 36.2

EAT/ Net Profit after Taxes/ EAC

(Earnings Available to common stock -5.7 54.3
holders)
common stock outstsanding ( Table 2 20 20
refer)
EPS -0.29 2.7
Expected EPS 2.72
Standard deviation of EPS* 2.10

Co- efficient of Variation of EPS

( standard deviation of EPS/expected 0.77
EPS)

Standard deviation of EPS*

EPS EPS-Exp EPS (EPS - Exp EPS)^2

-0.29 -3.0 9.0

2.7 0.0 0.0
5.7 3.0 9.0
Exp EPS 2.70
 Case 4: When the debt Ratio is 30%
Particulars
profitability of EBIT 0.25 0.5
EBIT 0 100
Less: interest (table 3 refer) 15 15
EBT/Net profit before taxes -15 85
less: taxes (40%) -6 34

EAT/ Net Profit after Taxes/ EAC

(Earnings Available to common stock -9 51.0
holders)
common stock outstsanding ( Table 2 17.5 17.5
refer)
EPS -0.51 2.9
Expected EPS 2.91
Standard deviation of EPS* 2.40

Co- efficient of Variation of EPS

( standard deviation of EPS/expected 0.82
EPS)

Standard deviation of EPS*

EPS EPS-Exp EPS (EPS - Exp EPS)^2

-0.51 -3.4 11.6

2.9 0.0 0.0
6.3 3.4 11.6
Exp EPS 2.90

Case 5: when the debt ratio is 40%

Particulars
profitability of EBIT 0.25 0.5
EBIT 0 100
Less: interest (table 3 refer) 22 22
EBT/Net profit before taxes -22 78
less: taxes (40%) -8.8 31.2

EAT/ Net Profit after Taxes/ EAC

(Earnings Available to common stock -13.2 46.8
holders)
common stock outstsanding ( Table 2 15 15
refer)
 EPS -0.88 3.1
Expected EPS 3.12
Standard deviation of EPS* 2.80

Co- efficient of Variation of EPS

( standard deviation of EPS/expected 0.90
EPS)

Standard deviation of EPS*

EPS EPS-Exp EPS (EPS - Exp EPS)^2

-0.88 -4.0 15.9

3.1 0.0 0.0
7.1 4.0 15.9
Exp EPS 3.11

Case 6: when the debt ratio is 50%

Particulars
profitability of EBIT 0.25 0.5
EBIT 0 100
Less: interest (table 3 refer) 33.75 33.75
EBT/Net profit before taxes -33.75 66.25
less: taxes (40%) -13.5 26.5

EAT/ Net Profit after Taxes/ EAC

(Earnings Available to common stock -20.25 39.8
holders)
common stock outstsanding ( Table 2 12.5 12.5
refer)
EPS -1.62 3.2
Expected EPS 3.18
Standard deviation of EPS* 3.40

Co- efficient of Variation of EPS

( standard deviation of EPS/expected 1.07
EPS)

Standard deviation of EPS*

EPS EPS-Exp EPS (EPS - Exp EPS)^2

-1.62 -4.81 23.2

3.2 0.0 0.0
8 4.81 23.1
Exp EPS 3.19
 Case 7: when the debt ratio is 60%
Particulars
profitability of EBIT 0.25 0.5
EBIT 0 100
Less: interest (table 3 refer) 49.5 49.5
EBT/Net profit before taxes -49.5 50.5
less: taxes (40%) -19.8 20.2

EAT/ Net Profit after Taxes/ EAC

(Earnings Available to common stock -29.7 30.3
holders)
common stock outstsanding ( Table 2 10 10
refer)
EPS -2.97 3.0
Expected EPS 3.03
Standard deviation of EPS* 4.24

Co- efficient of Variation of EPS

( standard deviation of EPS/expected 1.40
EPS)

Standard deviation of EPS*

EPS EPS-Exp EPS (EPS - Exp EPS)^2

-2.97 -6.16 38.0

3 -0.2 0.0
9 5.81 33.7
Exp EPS 3.01

The Coefficient of Variation measures the risk relative to the expected EPS, It is the preffered risk measure for use in compa
the firms financial leverage increases, so does its co efficient of variationof EPS. As expected, an increasing level of risk is a
level of leverag.

Table - 4
Expected EPS & Co efficient of Variation for alternative capital structures for cooke company
Capital Structure Debt Ratio Expected EPS Std. Dev of EPS
0 2.4 1.7
10 2.55 1.9
20 2.72 2.1
30 2.91 2.4
40 3.12 2.8
50 3.18 3.4
60 3.03 4.24
Probablity Distribution of EPS for 0%, 60%, 30% for cooke company (relative risk)

EPS @ 0% Mean std . Dev

0 2.4 1.7
2.4
4.8

EPS @ 60% Mean std . Dev

-2.97 3.03 4.29
3
9

EPS @ 30% Mean std . Dev

-0.51 2.91 2.4
2.9
6.3

Normal Distribution Curve of Expected EPS @ 0%, 60%, 30%

0.2500 0.2347

0.2000
0.1662
Normal distribution

0.1500
EP
EP
0.1000 0.0930 EP
0.0866 0.0866
0.0602 0.0613
0.0350 0.0500 0.0353

0.0000
-4 -2 0 2 4 6 8 10
Expected EPS

table 4
Capital structure debt ratio exp. Eps std dev of eps
 0 2.4 1.7
10 2.55 1.88
20 2.72 2.13
30 2.91 2.42
40 3.12 2.83
50 3.18 3.39
60 3.03 4.24

Expected EPS & Debt Rati o

3.5 3.12 3.18
2.91 3.03
3 2.72
2.55
2.4
2.5
Expected EPS

1.5

0.5

0
0 10 20 30 40 50 60 70
DEBT RATIO

Debt Rati o & COV of EPS

1.6
1.4
1.4
1.2 1.07
1 0.91
0.83
COV of EPS

0.74 0.78
0.71
0.8
0.6
0.4
0.2
0
0 10 20 30 40 50 60 70
Debt Ratio
mple
tal structure decision. It has obtained estimates of sales and the associated levels of earnings before interest and taxes (EBIT) fro
00; a 50% chance that sales will total Rs 6, 00, 000 and a 25% chance that sales will total Rs. 8, 00, 000. Fixed operating costs to

rent Capital Structure

Cooke Company (Rs. 000)

0.25
800

400

200
200

e-2
tive debt ratio for cooke company(rs. 000)
apital structure (rs. 000) Shares of
common stock
Equity outstanding
500 25
450 22.5
400 20
350 17.5
300 15
250 12.5
200 10
e-3
associated with cooke companys alternative capital structure

Interest (rs. 000)

0
4.5
9.5
15
22
 33.75
49.5

000) for cooke company

ratio is 0%

0.25
200
0
200
80

(prob 1*EPS 1)+(prob 2* EPS 2)*(prob

120 expected EPS =
3*EPS 3)

25

4.8
2.4
1.7

.71

(EPS-Exp
probability
EPS)2*probability

0.25 1.44
0.5 0
0.25 1.44
sum 2.88
Std deviation 1.7

ratio is 10%

0.25
200
4.5
195.5
78.2

117.3

22.5
 5.2
.55
.90

.75

(EPS-Exp
probability
EPS)2*probability

0.3 1.8
0.5 0.0
0.3 1.8
sum 3.5
Std deviation 1.9

ratio is 20%

0.25
200
9.5
190.5
76.2

114.3

20

5.7
.72
.10

.77

(EPS-Exp
probability
EPS)2*probability

0.3 2.2
0.5 0.0
0.3 2.2
sum 4.5
 Std deviation 2.1

Ratio is 30%

0.25
200
15
185
74

111

17.5

6.3
.91
.40

.82

probability (EPS-Exp
EPS)2*probability

0.3 2.9
0.5 0.0
0.3 2.9
sum 5.8
Std deviation 2.4

ratio is 40%

0.25
200
22
178
71.2

106.8

15
 7.1
.12
.80

.90

(EPS-Exp
probability
EPS)2*probability

0.3 4.0
0.5 0.0
0.3 4.0
sum 8.0
Std deviation 2.8

ratio is 50%

0.25
200
33.75
166.25
66.5

99.75

12.5

8.0
.18
.40

.07

(EPS-Exp
probability EPS)2*probability

0.3 5.8
0.5 0.0
0.3 5.8
sum 11.6
Std deviation 3.4
 ratio is 60%

0.25
200
49.5
150.5
60.2

90.3

10

9.0
.03
.24

.40

probability (EPS-Exp
EPS)2*probability

0.3 9.5
0.5 0.0
0.3 8.4
sum 17.9
Std deviation 4.24

reffered risk measure for use in comparing capital structures. As

xpected, an increasing level of risk is associated with increased

apital structures for cooke company

COV of EPS
0.71
0.75
0.77
0.82
0.9
1.09
1.4
 Normal distribution
0.0866
0.2347
0.0866

Normal distribution
0.0350
0.0930
0.0353

Normal distribution
0.0602
0.1662
0.0613

S @ 0%, 60%, 30%

EPS @ 0%
EPS @ 60%
EPS @ 30%

.0613
0.0353

8 10

cov of eps
 0.71
0.74
0.78
0.83
0.91
1.07
1.4

Maximum EPS

Financial risk

Business risk
 erest and taxes (EBIT) from its
00. Fixed operating costs total Rs. 2, 00,
 EBIT-EPS Appro
COOKE company
EPS @ Different debt
EBIT-EPS Approach
0% 30% 60%
0 0 -0.51 -2.97
100 2.4 2.91 3.03
200 4.8 6.34 9.03

EPS- EBIT Approach

10 9.03

8
6.34
6 4.8
series 1
4 3.03
2.91 Series 2
EPS(rs)

2.76
2.4 Series 3
2 1.2 First financial BEP
0 2nd financial BEP
-0.51
0
0 50 100 150 200 250
-2
-2.97

-4

EBIT (Rs)

Indifference Point
EPS = {(1-T)*(EBIT-I)-PD}/n
PD = Preference dividend
n= no. of shares the common stock
outstanding
i= interest

comparing cooke company 0% & 30% capital structure

(1-.40)*(EBIT-0)-0/25
for 30% ((1-.40)*(EBIT-15)-0)/17.5
EBIT = 50

comparing cooke company 0% & 30% capital structure

for 30% ((1-.40)*(EBIT-15)-0)/17.5

for 60% ((1-.40)*(EBIT-49.5)-0)/10
EBIT = 95.5

at 0% & 30% at 30% & 60%

Particulars
0% 30% 30% 60%
profitability of EBIT 0.5 0.5 0.5 0.5
EBIT 50 50 95.5 95.5
Less: interest (table 3 refer) 0 15 15 49.5
EBT/Net profit before taxes 50 35 80.5 46
less: taxes (40%) 20 14 32.2 18.4
EAT/ Net Profit after Taxes/ EAC
(Earnings Available to common stock 30 21 48.3 27.6
holders)
common stock outstsanding ( Table 2 25 17.5 17.5 10
refer)
EPS 1.2 1.2 2.76 2.76

required returns of cooke co. alternative cap. Structure

Estimated
Estimated value
return
cap. Str. Debt Ratio Exp. EPS of share(Exp.
required(ks)
(given) EPS/Ks)

0 2.4 0.115 20.87

10 2.55 0.117 21.79
20 2.72 0.121 22.48
30 2.91 0.125 23.28
40 3.12 0.14 22.29
50 3.18 0.165 19.27
60 3.03 0.19 15.95

Etimated values
25.00

20.00

15.00

10.00

5.00

0.00
0 10 20 30 40 50 60 70

EPS
3.5

2.5

2
 EPS
3.5

2.5

1.5

0.5

0
0 10 20 30 40 50 60 70
EBIT-EPS Approach

EBIT EPS
50 1.2
95.5 2.76
 Net Approach

INPUT data Case 1 Case 3

debt 3L 5L
EBIT
Cost of debt (Kd)
cost of equity(Ke)

Particulars
EBIT(net operating income)
less: interest on debenture
earnings available to equity holders(NI)
equity capitalization rate (Ke)
Market Value of equity (s) (NI/Ke)
Market value of debt (B)
Total value of firm(S+B)=V
overall cost of capital Ko= EBIT/V
Net Approach