CAPITAL STRUCTURE,EPS AND LEVERAGE

Capital Structure Defined

 The term capital structure is used to represent the
proportionate relationship between debt and equity.

 The various means of financing represent the financial

structure of an enterprise. The left-hand side of the balance
sheet (liabilities plus equity) represents the financial
structure of a company. Traditionally, short-term borrowings
are excluded from the list of methods of financing the firm’s
capital expenditure.
Terminologies

Capitalization

Capital
Structure

Financial
Structure
Capitalization Balance Sheet
Total
amount of Current Liabilities
Assets
Current

(in ) Debt
issued by a
Preference Shares
company
Fixed Assets

Equity Shares

Retained Earnings
 Balance Sheet

Current Liabilities Current Assets

Debt

Capital Preference Shares

Structure Fixed Assets
( % mix)
Equity Shares

Retained Earnings
 Balance Sheet

Current Liabilities Current Assets

Financial Debt

Structure Preference Shares

( % mix ) Fixed Assets

Equity Shares

Retained Earnings
What does it
Conclude !!
Capital Structure =
Financial Current
Structure liabilities
Importance of Capital Structure:

Reflects
t s a s a
Ac the
n a ge m
ma l
firm’s
en t t o o strateg
to r
i ca
I nd r i s k y
of e of
fi l
pro firm
t he
 Optimal Capital Structure
Capital structure or combination of debt and equity that leads
to maximum value of firm.

Maximises value of company and wealth of owners.

Minimises the company’s cost of capital.

 EBIT/EPS ANALYSIS
• EBIT/EPS Analysis. EBIT/EPS analysis allows
managers to see how different capital
structures affect the earnings and risk levels of
their firms.
• Specifically, it shows the relationship between
a firm's operating earnings, or earnings before
interest and taxes (EBIT) and its earnings per
share (EPS).
 EBIT/EPS ANALYSIS

 EBIT-EPS analysis is  To design

an approach which various
helps in designing the alternatives of
optimum capital debt, equity and
structure for the preference
company or the firm. shares in order
to maximize the
EPS at a given
level of EBIT.
 EBIT/EPS ANALYSIS (continue)

It examines how different capital

structures affect earnings available
to shareholders (Earning Per
Share).
It is the analysis of the effect of
financing alternatives on earnings
per share.
 To design the capital structure of
the firm in such a way so as to
minimize the cost of capital.
EBIT-EPS analysis is a method to
CALCULATION OF EBIT

Sales : xxxxx
(-)V.C : xxx

=Contribution : xxxxx
(-)F.C : xxxx

=EBIT {Earning Before Interest

and Taxes}
Uses of Earning
per share
EPS is used
particularly by
investors and
analysts to assess
the performance of
a company over a
period of time ,
and to compare
the performance of
a company with
 CALCULATION OF EPS

EBIT : xxxxx
(-)INTERSET : xxx

=EBT : xxxxx
(-)TAX : xx

=Earning for ESH : xxxxx

(÷) No. of E.S : xxx

= EPS {Earning Per Share}

xxx
Q: The present capital structure of Gupta Co. ltd. is:
4000, 5% Debenture of Rs 100 each Rs 4,00,000
2000, 8% P. Shares of Rs 100 each Rs 2,00,000
4000, Equity shares of Rs 100 each Rs 4,00,000
Rs 10,00,000
The present earning of the company before interest & taxes are
10% of the invested capital every year. The company is in need of
Rs 2,00,000 for purchasing a new equipment and it is estimated
that additional investment will also produce 10% earning before
interest & taxes every year.
The company has asked your advice as to whether the requisite
amount be obtained in the form of 5% Debenture or 8% P. Shares
Or equity shares of Rs 100 each to be issued at par. Examine the
problem in all its bearing and advice firm if the Corporate tax rate
is 50%.
STATEMENT SHOWING THE EPS UNDER EXISTING & PROPOSED ALTERNATIVE
ALTENATIVES
Particulars i ii iii
Present Debenture P. Share Eq. Share

EBIT 1,00,000 1,20,000 1,20,000 1,20,000

(-)Interest 20,000 30,000 20,000 20,000

EBT 80,000 90,000 1,00,000 1,00,000

(-)Tax 50% 40,000 45,000 50,000 50,000

EAT 40,000 45,000 50,000 50,000

(-)P. Dividend 16,000 16,000 32,000 16,000

ESH 24,000 29,000 18,000 34,000

(÷) No. of Equity
Shares 4,000 4,000 4,000 6,000

EPS Rs 6.00 Rs 7.25 Rs 4.50 Rs 5.67

Change in EPS - +1.25 -1.50 -0.33
 Problem No 2
A company is expecting EBIT of Rs. 5,00,000 per annum on investment of Rs.
10,00,000. Company is in need of another Rs. 10,00,000 for its expansion
activities. Company can raise this amount by either equity shares capital or
12% preference share capital or 10% debentures. The company is
considering the following financing patterns:

a. 10,00,000 through issue of Equity Shares at par;

b. 5,00,000 by issue of Equity Share Capital and remaining 5,00,000 by issue
of Debentures;
c. 5,00,000 through Equity Shares and 2,50,000 through 12% Preference
Share Capital and remaining 2,50,000 through 10% Debentures.;
d. 5,00,000 through Debt and 2,50,000 through Equity Shares and
remaining 2,50,000 through 12% Preference Share Capital.

Find out the best financing mix assuming 50% tax rate
EBIT – EPS BREAK EVEN ANALYSIS:
• The EBIT level at which the EPS is the same for two alternative
financial plan is referred to as the indifference point/level.

• Financial break even point obtained by a company at a given

level of EBIT for which the firm’s EPS is zero.

• If EBIT is less than financial break even point, then the EPS is
negative.

• If EBIT is more than the financial break even point, then more
and more fixed cost financing option can be used by a firm.
 DRAWBACKS
• The EBIT-EPS approach is not always the best tool for making
decisions about capital structuring.

• The EBIT-EPS approach places heavy emphasis on maximizing

earnings per share rather than controlling costs and limiting risk.

• It's important to keep in mind that as debt financing increases, investors

should expect a higher return to account for the greater risk; this is
known as a risk premium.

• The EBIT-EPS approach does not factor this risk premium into the cost
of financing, which can have the effect of making a higher level of debt
seem more advantageous for investors than it actually is.
 LEVERAGE
Leverage is the employment of an asset/source of finance for
which firm pay fixed cost/fixed return. It may of three types:

• Operating Leverage
• Financial Leverage
• Combined Leverage
 Leverage

Operating Financial Combined

Leverage Leverage Leverage
 OPERATING LEVERAGE
• It may be defined as the firm’s ability to use fixed operating
costs to magnify the effects of changes in sales on its earnings
before interest and taxes.

• Operating leverage is associated with investment (assets

acquisition) activities.

Degree of Operating Leverage (DOL) = Contribution/EBIT

Percentage change in EBIT / Percentage change in sales
 FINANCIAL LEVERAGE
• Financial leverage is the ability of the firm to use fixed
financial charges to magnify the effects of changes in EBIT on
the firm’s earnings per share.

• Degree of financial leverage (DFL)=EBIT/EBT

Percentage change in EPS divided by Percentage change in EBT

 COMBINED LEVERAGE
• The degree of combined leverage may be defined as the
percentage change in EPS due to the percentage change in
sales.

• Thus the combined leverage is:

% Change in EBIT % Change in EPS % change in EPS

CL  * 
% change in sales % Change in EBIT % Change sales
 Case 1
• A firm has sales of Rs. 10,00,000, variable cost
of Rs. 7,00,000 and fixed costs of Rs. 2,00,000
and debt of Rs. 5,00,000 at 10% rate of
interest.
• What are the operating, financial and
combined leverages. If the firm wants to
double its earnings before interest and tax
(EBIT), how much of a rise in sales would be
needed on a percentage basis?
 Case 2

• The balance sheet of Well Established Company is as follows:

Liabilities Amount Assets Amout

Equity share capital 60000Fixed Assets 150000
Retained Earning 20000Current Assets 50000
10% Long term Debt 80000
Current Liabilities 40000
200000 200000

• The company’s total assets turnover ratio is 3, its fixed operating costs
are Rs.1,00,000 and its variable operating cost ratio is 40%. The income
tax rate is 50%. Calculate the different types of leverages given that the
face value of share is Rs.10.
• (Total Assets Turnover Ratio = Sales / Total Assets)