Unit-3 Capital Structure:

Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of
long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings. It refers to the relationship between
the various long-term sources financing such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure is
the important decision of the financial management because it is closely related to the value of the firm.

Capital structure of a company is made up of long-term debt and equity that comprise a firm’s financing of its assets. It is the permanent
financing of a firm represented by long term debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short
term borrowings.

According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and
common stock equity”.

According to the definition of Presana Chandra, “The composition of a firm’s financing consists of equity, preference, and debt”.

FINANCIAL STRUCTURE
The term financial structure is different from the capital structure. Financial structure shows the pattern total financing. It measures the extent to
which total funds are available to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.

Financial Structures Capital Structure

It includes both long-term and short-term sources of funds It includes only the long-term sources
of funds.
It means the entire liabilities side of the balance sheet. It means only the long-term liabilities
of the company.
Financial structures consist of all sources of capital. It consist of equity, preference and
retained earning capital.
It will not be more important while determining the value of the firm. It is one of the major determinations of
the value of the firm.

Importance of capital structure:

 Value maximization: Capital structure maximizes the market value of firm, if a firm having a properly designed capital structures the
aggregate value of the claims and ownership interests of the shareholders are maximized.

 Cost Minimization: By determining a proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.

 Increase the share price: It help to increase the market value of the share by increasing EPS of the ordinary shares.

 Investment opportunity: Capital structure increases the ability of the firm to find new wealth- creating new investment opportunity.
With proper capital gearing, also increase the confidence of supplier of debts.

 Growth of the company: it helps to increase ROI and growth by increasing firm’s opportunity to engaged in future wealth creating
investments.

FACTORS DETERMINING CAPITAL STRUCTURE

Cost of Capital: Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term finance such as equity
and debt consist of fixed cost while mobilization. If firm can arrange borrowed fund at low rate of interest then it will prefer more debt as
compared to equity. When the cost of capital increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the
cost of capital.

Cash flow position: Depends upon the ability of business to generate enough cash flow to pay a fixed rate of interest to debenture holders,
dividend to preference shares and interest on loan. Sometimes company makes sufficient profit but it is not able to generate sufficient cash
inflow, before including the debt in capital Structure Company must analyze properly the liquidity of its working capital.

Interest coverage ratio: while determining capital structure, company must consider ICR=EBIT/Interest refers no. of times company cover the
interest payment obligation.

Leverage: It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing such as debt, equity and
preference share capital. It is closely related to the overall cost of capital
Tax Rate: High tax rate makes debt interest cheaper as compare to equity dividend. So high tax rate prefer debt whereas at low tax rate we can
prefer equity in capital structure.
Return on Investment: helps in determining the capital structure. If ROI is more than rate of interest then company must prefer debt in its capital
structure whereas if ROI is less than rate of interest to be paid on debt, then company should avoid debt and prefer equity capital.

Floatation costs: Floatation costs include the cost of promotion, underwriting cost etc. while arranging the funds companies cannot ignore this
factor because along with cost there are many legal formalities to be completed before entering into capital market

Trading on Equity- The word “equity” denotes the ownership of the company. It means taking advantage of equity share capital to borrowed
funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It
is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate
of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity
shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.

Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got
maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably
less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their
voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.

Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans.
Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to
plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans.

Choice of investors- The company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure
should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and
debentures are generally raised keeping into mind conscious investors.

Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression
period, the company’s capital structure generally consists of debentures and loans. While in period of boons and inflation, the company’s capital
should consist of share capital generally equity shares.

Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long
period it goes for issue of shares and debentures.

Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet fixed
commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company
is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having
unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.

Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other
hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and
borrowings from financial institutions. The bigger the size, the wider is total capitalization.

OPTIMUM CAPITAL STRUCTURE:

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is
maximum. It combination of debt and equity, that leads to the maximum value of the firm.

Objectives of Capital Structure

1. Maximize the value of the firm and returns
2. Minimize the overall cost of capital and risks
3. Proper liquidity
4. Full utilization
5. Preservation of control
Forms of Capital Structure: Capital structure pattern varies from company to company and the availability of finance.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.

Capital structures decisions:

 Trading on equity
 Capital gearing
 cost of capital
CAPITAL STRUCTURE THEORIES
Capital structure is the major part of the firm’s financial decision which affects the value of the firm and it leads to change EBIT and market
value of the shares. There is a relationship among the capital structure, cost of capital and value of the firm. The aim of effective capital structure
is to maximize the value of the firm and to reduce the cost of capital.

1. Traditional theories
2. Modern theories
 Net income approach
 Net operating income approach
 Modi Miller approach

Traditional Approach: It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also called as intermediate
approach. According to the traditional approach, mix of debt and equity capital can increase the value of the firm by reducing overall cost of
capital up to certain level of debt. Traditional approach states that the K o decreases only within the responsible limit of financial leverage and
when reaching the minimum level, it starts increasing with financial leverage.
Assumptions:
Capital structure theories are based on certain assumption to analysis in a single and convenient manner:
 There are only two sources of funds used by a firm; debt and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance remains constant. Co s t

 The operating profits (EBIT) are not expected to grow. ke

 The business risk remains constant.
 The firm has a perpetual life. ko
 The investors behave rationally.

kd

De b t
Case: 1
Compute the total value of ABC ltd, value of quity shares and overall cost of capital from the following information.
Net operating income -3,00,000
Total investment- 20, 00,000
Equity capitalization rate:
(a) If the company uses no debt
(b) If the company uses 10,00,000 debentures
(c) If the company uses 15,00,000 debentures
Assume that 10,00,000 debentures can be raised at 6% interest and 15,00,000 debentures can be rasied at 8%interest.

Net Income (NI) Approach: Net income approach suggested by the Durand. According to this approach, the capital structure decision is relevant
to the valuation of the firm. In other words, a change in the capital structure leads to a corresponding change in the overall cost of capital as well
as the total value of the firm. According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of
firm.
Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
4. Cost of equity and total capitalization is remain the same
5. The total capital requirement of the firm are given and remain constant.
where
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of the equity can be ascertained by the following formula:
S = NI /K e
where
NI = Earnings available to equity shareholder

Overall cost of capital (Ko)=EBIT/Value of the firm

Format for calculating value of the firm on the basis of NI approach.
Particular Rs
Net operating income (EBIT)
Less: interest on debenture (i)
Earnings available to equity holder (NI)
Equity capitalization rate (K e )
Market value of equity (S)
Market value of debt (B)
Total value of the firm (S+B)
Overall cost of capital = K o = EBIT/V (%)

Case-2

R ltd has 10% Debentures of 10,00,000. The expected annual net income before interest and tax of the company is 4,00,000.The equity
capitalization rate of the company is 15%. Compute according to net income theory-

(a) The existing total market value and the overall cost of capital of the company.

(b) The impact on total market value and overall cost of capital if management takes a decision to increase debentures by 600000 by reducing
equity.

(c) The impact on total market value and overall cost of capital if management takes a decision to reduce its debentures by 600000 through issue
of equity shares.

Net Operating Income (NOI) Approach:

Another modern theory of capital structure, suggested by Durand. This is just the opposite to the Net Income approach. According to this
approach, Capital Structure decision is irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the capital
structure changes.
According to this approach, the change in capital structure will not lead to any change in the total value of the firm and market price of shares as
well as the overall cost of capital.

NI approach is based on the following important assumptions;

 The overall cost of capital remains constant, in respect any change in capital structure
 There are no corporate taxes;
 The market capitalizes the value of the firm as a whole;
Value of the firm (V) can be calculated with the help of the following formula
V= EBIT /K o
Where, V = Value of the firm
EBIT = Earnings before interest and tax
K o = Overall cost of capital
Ke=EBIT-I/S or EBIT-I/V-D

Case:3
VK ltd has an expected annual net operating income before interest and tax of 3,00,000. The cost of debtis 12% and the outstanding debt amounts
to 10,00,000. the overall capitalisation rate of the company is 15%. you are required to calculate total market value and equity capitalisation rate
of the company according to net operating income theory-
(a) for present capital structures
(b) if the company decides to raise a sum of 5,00,000 through debt at a cost of 12% and uses the proceeds to pay off the equity shareholders.
(c) if the company decides to redeem debt worth of 5,00,000 by issue of equity share.

Case: A company expects a net operating income 1, 00,000.It has 5,00,000 6% debenture. The overall capitalization rate is 10%. Calculate the
value of the firm and equity capitalization cost according to the NOI approach. If the debenture debt is increased to 7,50,000 what will be the
effect on the value of the firm and equity capitalization rate?
Modigliani and Miller Approach:
Modigliani and Miller approach states that the financing decision of a firm does not affect the market value of a firm in a perfect capital market.
In other words MM approach maintains that the average cost of capital does not change with change in the debt weighted equity mix or capital
structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:
• There is a perfect capital market/ no transaction cost.
• There are no retained earnings.
• There are no corporate taxes.
• The investors act rationally.
• The dividend payout ratio is 100%.
• The business consists of the same level of business risk.
Value of firm=S+D
Value of unlevered firm (equity)= EBIT(1-T)/ Ke
Value of levered firm (equity +debts) =value of firm (equity)+value of debt x tax rate
EBIT/Ke
Where EBIT = Earnings before interest and tax
K o = Overall cost of capital
t = Tax rate Capital Structure

Case: A company has earnings before interest and taxes of 1,00,000. It expects a return on its investment at rate of 12.5%. you are required to
find out the total value of the firm according to the MM theory.

Value of unlevered firm = EBIT/Ke

Case:4
Firm A and B are identical expect that A does not use any debt in its financing. While B has 1,00,000 5% debenture in its financing. Both the firm
EBIT of 2,50,000 and the equity capitalization rate 10%. Assume that all the MM assumptions are met with 50% tax rate.

EBIT (1-T)/Ke
25000/10% (1-.50) =125,000

mMarket value of Y=which uses debt financing of 1,00,000.

V= 125000+50%+100,000=175000

EBIT is 6 lakhs and the equity capitalisation rate for firm A is 12%. What would be the value for each firm according to M-M approach

Leverage:
It is used for a technique by which more weight is raised with less power. Whereas in finance leverage is there on account of FC. If any firm is
using some part of FC capital then it has leverage which can be used for raising profitability and financial strength of the firm. Leverage refers to
furnish the ability to use fixed cost assets or funds to increase the return to its shareholders. James Horne has defined leverage as, “the
employment of an asset or fund for which the firm pays a fixed cost or fixed return.

Types of Leverage:
1. Operating Leverage
2. Financial Leverage
3. Composite Leverage

1. OPERATING LEVERAGE
The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company.
Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings
before interest and taxes. Operating leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have
a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating
leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis.
Operating leverage can be calculated with the help of the following formula:
OL = C/ OP or EBIT
Where,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
Degree of Operating Leverage
The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It can be
calculated with the help of the following formula:

DOL=Percentage change in profits / Percentage change in sales

Uses of Operating Leverage

1. Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company. If
any change in the sales, it will lead to corresponding changes in profit. Operating leverage helps to identify the position of fixed cost and variable
cost.
2. Operating leverage measures the relationship between the sales and revenue of the company during a particular period.
3. Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.
4. Operating leverage describes the overall position of the fixed operating cost.

Financial leverage: as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”.
It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders.

“The use of long-term fixed interest bearing debt and preference share capital along with
share capital is called financial leverage or trading on equity”. Financial leverage may be favourable or unfavourable depends upon the use of
fixed cost funds. Favourable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost
of their use. Hence, it is also called as positive financial leverage. Unfavourable financial leverage occurs when the company does not earn as
much as the funds cost. Hence, it is also called as negative financial leverage.

FL=OP/PBT
Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.

Degree of Financial Leverage: The percentage change in taxable profit as a result of percentage change in earning before interest and tax
(EBIT). This can be calculated
by the following formula
DFL= Percentage change in taxable Income /Precentage change in EBIT

Uses of Financial Leverage

1. Financial leverage helps to examine the relationship between EBIT and EPS.
2. Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.
3. Financial leverage locates the correct profitable financial decision regarding capital structure of the company.
4. Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.
5. If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will
decrease.
INCOME STATEMENT
DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE
Operating Leverage Financial Leverage

1. Operating leverage is associated with investment activities of the 1. Financial leverage is associated with financing activities of the
company. company.
2. OL consists of fixed operating expenses of the company. 2. Financial leverage consists of operating profit of the company.
3. It represents the ability to use fixed operating cost. 3. It represents the relationship between EBIT-EPS.
4. Operating leverage can be calculated by OL =C/EBIT 4. Financial leverage can be calculated by
5. A percentage change in the profits resulting From a percentage change FL =EBIT/EBT
in the sales is called as degree of operating leverage. 5. A percentage change in taxable profit is the result of % change in
6. Trading on equity is not possible while the Company is operating EBIT.
leverage. 6. Trading on equity is possible only when the company uses financial
7. Operating leverage depends upon FC and VC leverage.
8. Tax rate and interest rate will not affect the Operating leverage. 7. Financial leverage depends upon the operating profits.
8. Financial leverage will change due to tax rate and interest rate.

COMBINED LEVERAGE: When the company uses both financial and operating leverage to magnification of any change in sales into a larger
relative changes in earning per share. Combined leverage is also called as composite leverage or total leverage. Combined leverage express the
relationship between the revenue in the account of sales and the taxable income.

CL=OLxFL

Degree of Combined Leverage: The percentage change in a firm’s earning per share (EPS) results from one percent change in sales. This is also
equal to the firm’s degree of operating leverage (DOL) times its degree of financial leverage (DFL) at a particular level of sales.
DCL= % change in EPS/% change in Sales

EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and shows ways to maximize EPS. Hence EBIT-EPS analysis
may be defined as ‘a tool of financial planning that evaluates various alternatives of financing a project under varying levels of EBIT and suggests the best
alternative having highest EPS and determines the most profitable level of EBIT’.

Concept of EBIT-EPS Analysis:

The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative methods of financing at different levels of EBIT. Under this we
examine the effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial plans.

EBIT-EPS analysis is used for making the choice of the combination and of the various sources. It helps select the alternative that yields the highest EPS.

Advantages of EBIT-EPS Analysis: We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS under various
financing plans with varying levels of EBIT. It helps a firm in determining optimum financial planning having highest EPS.

Financial Planning: Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial planning the objective of the firm lies
in maximizing EPS. EBIT-EPS analysis evaluates the alternatives and finds the level of EBIT that maximizes EPS.
Comparative Analysis: EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines and markets. It identifies the EBIT
earned by these different departments, product lines and from various markets, which helps financial planners rank them according to profitability and also
assess the risk associated with each.
Performance Evaluation: This analysis is useful in comparative evaluation of performances of various sources of funds. It evaluates whether a fund
obtained from a source is used in a project that produces a rate of return higher than its cost.
Determining Optimum Mix: EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By emphasizing on the relative value of
EPS, this analysis determines the optimum mix of debt and equity in the capital structure. It helps determine the alternative that gives the highest value of
EPS as the most profitable financing plan or the most profitable level of EBIT.

Limitations of EBIT-EPS analysis: Finance managers are very much interested in knowing the sensitivity of the earnings per share with changes in EBIT.

No consideration for risk-Leverage increase the level of risk, EBIT-EPS analysis ignores the risk factor. When a corporation, on its borrowed
capital, earns more than the interest. it has to pay on debt, any financial planning can be accepted irrespective of risk.

Contradictory results- where different alternatives financing plans new equity shares are not taken into consideration. Even the comparison
becomes difficult if the number of alternatives increase.

Over capitalization-It cannot determine the state of over capitalization of a firm. Beyond the certain level, additional capital cannot be employed
to produce a return in excess of the payments that must be made for its use. But this aspect is ignored in EBIT-EPS analysis.

Point of indifference

Another important tool that managers use to help them choose b/w alternative cost structures in the difference point. it is the level of volume at which total
costs and profits are the same under both cost structures. If the company operated at that level of volume, the alternative used would not matter becouse
income would be the same in every option. At the cost indifference point, total cost(FC and VC) associated with the two alternatives are equal.

There may be two methods of production, one production method is superior to another ande vice-versa. There is a need to know at which level of
production. It will be desirable to shift from one production method to another method. this point is called as cost indifference point and at this point total
cost of two production is same.

Cost indifference point=Differential FC/Differential VC per unit

Indifference Points:

The indifference point, often called as a breakeven point, is highly important in financial planning because, at EBIT amounts in excess of the EBIT
indifference level, the more heavily levered financing plan will generate a higher EPS. On the other hand, at EBIT amounts below the EBIT indifference
points the financing plan involving less leverage will generate a higher EPS.

Indifference points refer to the EBIT level at which the EPS is same for two alternative financial plans. According to J. C. Van Home, ‘Indifference point
refers to that EBIT level at which EPS remains the same irrespective of debt equity mix’. The management is indifferent in choosing any of the alternative
financial plans at this level because all the financial plans are equally desirable. The indifference point is the cut-off level of EBIT below which financial
leverage is disadvantageous. Beyond the indifference point level of EBIT the benefit of financial leverage with respect to EPS starts operating.

The indifference level of EBIT is significant because the financial planner may decide to take the debt advantage if the expected EBIT crosses this level.
Beyond this level of EBIT the firm will be able to magnify the effect of increase in EBIT on the EPS.

Financial break-even point is the level of earnings before interest and taxes that will result in zero net income or zero earnings per share. It
equals the company’s interest expense plus dividends paid to preferred stock-holders and associated taxes. Interest expense and preferred
dividends are obligatory payments hence they are included in financial break-even calculation while common dividends, being optional, are
excluded. While the operating BE P analysis finds out the sales dollar level or sales units needed to result in zero operating margin i.e. earnings
before interest and taxes (EBIT), the financial break-even deals with the bottom line of the company’s income statement. Financial break-even
point attempts to find EBIT that results in zero net income. The relationship between EBIT and net income can be expressed as follows:

Net Income
= EBIT × (1 − Interest Expense) × (1 − Tax Rate) − Preferred Dividends

EBIT=Pref.Dividend/(1-T)

Financial Breakeven Point (BEP) refers to the point where the total cost line and sales line intersect. It indicates the level of production and sales where
there is no profit and no loss because here the contribution just equals to the fixed costs. Similarly financial breakeven point is the level of EBIT at which
after paying interest, tax and preference dividend, nothing remains for the equity shareholders. In other words, financial breakeven point refers to that level
of EBIT at which the firm can satisfy all fixed financial charges. EBIT less than this level will result in negative EPS. Therefore EPS is zero at this level of
EBIT. Thus financial breakeven point refers to the level of EBIT at which financial profit is nil.