Capital Structure Decision

Prof(Dr.) Harsh Vardhan

 Objective
▪ Capital Structure What? and its Process.
▪ Cost-Volume-Profit(CVP) Analysis
▪ Leverage Analysis
▪ Operating leverage
▪ Financial leverage.
▪ Total Leverage

▪ EBIT– EPS Analysis

▪ ROI – ROE Analysis
▪ Comparative Analysis
▪ Guidelines for Capital Structure Planning
▪ Capital Structure Policies in Practice
CF/MDI/Harsh/13 2
 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

CF/MDI/Harsh/13 3
 Focus Area
Q. How optimal Capital Structure could be determined in practice? Which capital
structure would maximize value of firm?
▪ The Capital Structure decision could be done by different analysis:
▪ By examining impact of Operating , Financial & Total Leverage on Capital Structure.
▪ By understanding how alternative Capital Structures influence EPS.
▪ To analyze impact of alternative Capital Structures on ROE.
▪ Analysis based on certain ratios- interest coverage ratio, cashflow coverage ratio, debt
service coverage ratio and fixed service coverage ratio.
▪ Analysis based on level of debt that can be serviced by expected cash flows.
▪ Analysis based on performance of comparable firms.

CF/MDI/Harsh/13 4
 Cost-Volume Profit(CVP) Analysis

▪ Fixed cost is that portion of the total cost that does not depend on
volume, this cost remains same no matter how much is produced.
▪ Variable cost is that portion of the total cost that is dependent on and
varies with the volume.
▪ Marginal cost the rate of change of total cost with respect to volume.
▪ Break even point is the volume at which total revenue equals total cost.

CF/MDI/Harsh/13 5
 Cost-Volume-Profit(CVP) Analysis
▪ CVP Analysis deals with the interrelationship between costs and volume
and how they impact profit.
▪ Profit = Revenue -Total cost ….1
Revenue=Total Cost+ Profit ……2
where Total Cost=Fixed cost + Variable cost
Thus , Equation 2 is:
Unit sold*Price=Fixed cost + Variable cost + Profit
Qp = f + Qv+ N …..The CVP model……3
Q=Unit sold , v=Variable cost, f=Fixed cost, p=Unit selling price,
N=Operating Profit[EBIT]
CF/MDI/Harsh/13 6
▪ Qp=f + Qv + N
▪ Q(p-v)=f + N, or
▪ [N= EBIT= Q(p-v) - f ]
▪ f+N= Q(p-v)
(f+ N)
▪ Q=
(p−v)
▪ (p-v)= contribution margin
(p−v)
▪ = pv ratio
p
▪ Q(p-v)=Total contribution

CF/MDI/Harsh/13 7
 (f+ N)
▪ Q=
(p−v)
▪ For Break Even, N=0
Thus
f
▪ Break Even Quantity(BEQ) ,Q=
(p−v)
f
▪ Break Even Sales(BES) , Qp=
{(p−v)/p}

CF/MDI/Harsh/13 8
 Calculation of Net Profit After Tax
Rs
Sales xxx
Less :Cost of Goods sold xxx
Gross Profit xxx
Less Operating Expenses xxx
Operating Profit[EBIT] xxx
Less Interest xxx
Tax xxx xxx
Net Profit After Tax[PAT] xxx
EPS= PAT/Number of Equity Shares
P/E ratio= Price per Share/Earning per Share
CF/MDI/Harsh/13 9
▪ Operating Expense
▪ Consists of general administrative expenses, selling distribution expenses.
▪ Operating Cycle
▪ The operating cycle of a firm begins with acquisition of raw material and ends with
collection of receivables.
▪ EBIT[Profit or Earning Before Interest &Tax]
▪ It is a measure of profit which is not influenced by financial leverage & tax factor. Used
in inter-firm comparison.
▪ Interest
▪ It is expense incurred for funds such as term loan, debenture,public deposit and
working capital advances.

CF/MDI/Harsh/13 10
 The Capital Structure Decision Process

11 CF/MDI/Harsh/13
 While making the Financing Decision...
▪ How should the investment project be financed?
▪ Do the way in which the investment projects are financed matters?
▪ How does financing affect the shareholders’ risk, return and value?
▪ Does there exist an optimum financing mix in terms of the 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 financing
policy?

12 CF/MDI/Harsh/13
 Leverage Analysis
▪ Leverage arises from the existence of fixed cost.
▪ There are two kinds of leverage
▪ Operating leverage &
▪ Financial leverage.

▪ Operating leverage arises from the firm’s fixed Operating/production

cost.
▪ (salaries, rent, deprecation, property tax etc)

▪ Financial leverage arises from the firm’s fixed financing cost.

▪ Interest on debt.
CF/MDI/Harsh/13 13
 Income Statement Format

Sales
Operating Less: Variable costs
Contribution
leverage Less: Fixed operating costs
Profit before interest and tax
Less: Interest on debt Total
Profit before tax leverage

Financial Less: Tax

leverage Profit after tax
Less: Preferred dividend
Equity earnings

CF/MDI/Harsh/13 14
 Some Relationships

▪ Contribution= Q (P – V) I = Interest cost on Debt

▪ EBIT or PBIT = Q (P – V) – F EBIT =Profit before interest & Tax
▪ PAT = (EBIT – I) ( 1 – T) PBT= Profit before Tax
(EBIT – I) (1 – T) – Dp T= Corporate IT
▪ EPS = PAT =Profit after Tax
N
[Q (P – V) – F – I] (1 – T) – Dp Dp= Preferred Dividend
▪ EPS =
N N= Number of Outstanding shares
EPS= Earning per Share

CF/MDI/Harsh/13 15
 Operating Leverage

▪ Operating Leverage affects a firm’s Operating Profit (EBIT).

▪ Operating Leverage refers to extent to which firm has fixed operating
cost. A firm with high Operating Leverage will have relatively high fixed
cost in comparison with low Operating Leverage.
▪ The sensitivity of Profit Before Interest and Taxes (PBIT or EBIT) to
changes in unit sales is referred as the Degree of Operating Leverage
(DOL).

CF/MDI/Harsh/13 16
 Degree of Operating Leverage
▪ The Degree of Operating Leverage [DOL] measures sensitivity of
Operating Income [EBIT] to changes in revenues (or quantity sold) .
%𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝐸𝐵𝐼𝑇
▪ DOL =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄
Δ EBIT Δ[Q (P−V)−F]
EBIT [Q (P−V)−F]
▪ DOL = ΔQ = ΔQ
Q Q
▪ As EBIT = [Q (P-V)-F], EBIT+F= Q (P-V)=Contribution
▪ ΔF=0, F is fixed cost, on simplification
Q(P−V) 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 EBIT+F
▪ DOL = = or [ ]
Q (P−V)−F 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇

CF/MDI/Harsh/13 17
 Problem
▪ A firm sells a product at ₹ 1,000 per unit. Its variable costs are ₹ 500 per unit
and fixed operating cost is ₹ 200,000.
▪ Consider level of production of 500 & 600 units.
▪ Find DOL and discuss % increase in EBIT due to increase in sales.

Given A B
Units Q 500 600
P in rupee 1,000 1,000
Variable cost per unit V 500 500
Fixed Operating Cost f 2,00,000 2,00,000

CF/MDI/Harsh/13 18
 Solution
A B % Change
Units Q 500 600 20.00%
P in rupee 1000 1000
Revenue P*Q 500000 600000
Variable cost per unit V 500 500
Variable Operating Cost Q*V 250000 300000
Fixed Operating Cost f 2,00,000 2,00,000
Contribution =Revenue -Variable Cost=Q(P-V) 250000 300000
EBIT= Q(p-v)-f 50,000 1,00,000 100.00%
DOL =Contribution/EBIT= Q(P-V) /EBIT 5.0 3.0
20% increase in sales results in 100% increase in EBIT.
20% decline in sales results in 100% decrease in EBIT.
1% Change in sales results in more than 1% change in EBIT

CF/MDI/Harsh/13 19
 Application of Operating Leverage
▪ DOL measures the % change in EBIT which is due to 1% change in the level
of output.
▪ DOL helps in :
▪ Understand how EBIT would change given certain change in out put.
▪ Measuring Business Risk
Business risk refers to variability in EBIT.
DOL up to some extent measures Business risk.
Larger the DOL the greater is variability around forecasted value of EBIT.

CF/MDI/Harsh/13 20
 Meaning of Financial Leverage

▪ The use of the fixed-charges source of funds, such as debt and preference capital
along with the owners’ equity in the capital structure, is described as Financial
Leverage or gearing or trading on equity.
▪ The Financial Leverage employed by a company is intended to earn more return
on the fixed-charge funds than their costs.
▪ The surplus (or deficit) will increase (or decrease) the return on the owners’
equity. The rate of return on the owners’ equity is levered above or below the
rate of return on total assets.

21 CF/MDI/Harsh/13
 Measures of Financial Leverage
▪ Debt ratio
▪ Debt - Equity ratio
▪ Interest coverage[PBIT/Interest ]
▪ The first two measures of financial leverage can be expressed either in
terms of book values or market values. These two measures are also known
as measures of capital gearing.
▪ The third measure of Financial Leverage, commonly known as coverage
ratio.
▪ The reciprocal of interest coverage is a measure of the firm’s income
gearing.

22 CF/MDI/Harsh/13
 Financial Leverage
▪ While Operating Leverage arises from existence of fixed operating cost,
Financial Leverage emanates from the existence of fixed interest expense.

▪ Financial Leverage which is due to the fixed interest cost arising from use of
the debt capital.

▪ A firm with high financial leverage will have relatively high financing cost
compared to firm with low financial leverage.

▪ When a firm has fixed interest expenses,1% change in Profit Before Interest in
Taxes ( PBIT) leads to more than 1% change in Profit Before Tax (or PAT or EPS)
CF/MDI/Harsh/13 23
 Financial Leverage

▪ The sensitivity of Profit Before Tax (or profit after tax or earnings per share)
to changes in PBIT is referred as the Degree of Financial Leverage [DFL].
% 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑃𝐵𝑇
▪ DFL =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝐵𝐼𝑇
Δ PBT Δ[Q (P−V)−F−I] Δ[Q (P−V)]
PBT =
▪ DFL = ΔPBIT PBT = PBT
Δ[Q (P−V)−F] Δ[Q (P−V)]
PBIT PBIT PBIT

PBIT Profit Before Interest and Tax

▪ DFL = =
PBT Profit Before Tax

CF/MDI/Harsh/13 24
 Example: Two Cases
▪ Let in case 1 ,EBIT = ₹50,000,Fixed Interest Expenses is I= ₹ 30,000 and
tax rate T =50%. Number of shares out standing = 10,000.
▪ For case 2 ,EBIT = ₹ 60,000.
Case 1 Case 2 % Change
EBIT 50,000 60,000 20.00%
Interest expense 30,000 30,000
Profit Before TAX PBT 20,000 30,000 50.00%
TAX@50% 10,000 15,000
Profit AFTER TAX PAT 10,000 15,000 50.00%
Number of Shares 10,000 10,000
Earning Per Share 1 1.5 50.00%
DFL =EBIT/PBT 2.5 2.0 -20.00%
20% increase in PBIT results in 50% increase in PBT.
20% decline in EBIT results in 50 % decrease in PBT.

CF/MDI/Harsh/13 25
 Financial Leverage
▪ The Degree of Financial Leverage (DFL) indicates the responsiveness
of EPS to changes in EBIT.
Δ EPS
EPS
▪ DFL= ΔEBIT
EBIT
[Q (P − V) − F − I] (1 −T) −Dp
▪ On substituting EPS = in above equation
N
and simplifying.
𝐸𝐵𝐼𝑇
▪ DFL= 𝐷𝑝
𝐸𝐵𝐼𝑇−𝐼−
1−𝑇

CF/MDI/Harsh/13 26
 Example
▪ Consider the data for company ABC, P=₹ 150, V= ₹ 100, F= ₹ 120,000,
I= ₹ 20,000, T=50% and Dp= ₹ 10,000.
▪ DFL is a function of the level of EBIT. Let it is computed at two
different values of EBIT= ₹ 50,000 and EBIT= ₹ 100,000
𝐸𝐵𝐼𝑇
▪ DFL= 𝐷𝑝 ,Thus
𝐸𝐵𝐼𝑇−𝐼−
1−𝑇
50,000
▪ DFL(EBIT at ₹ 50,000) = 10,000 = 5.00
50,000−20,000−
1−0.5
100,000
▪ DFL(EBIT at ₹ 100,000) = 10,000 = 1.67
100,000−20,000−
1−0.5

CF/MDI/Harsh/13 27
 Application Of Financial Leverage
▪ DLF measures % of change in EPS w.r.t 1% change in EBIT.
▪ Therefore it enables:
▪ How EPS will change given certain change in EBIT
▪ Measure Financial Risk as it measures variability of EPS due to employment of debt
capital.
▪ Thus DLF captures the effect of debt interest which quantifies Financial Risk

CF/MDI/Harsh/13 28
 Total Leverage or Combined Leverage
▪ The sensitivity of Profit Before Tax (or PAT or EPS) to changes in unit
sales is referred as the Degree of Total (or combined) Leverage (DTL).

Δ PBT Δ[Q (P−V)−F−I]

%𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝐵𝑇
▪ DTL = = PBT
ΔQ = PBT
ΔQ
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄
Q Q

Δ[Q (P−V)]
PBT Q (P−V)
▪ DTL = ΔQ =
PBT
Q
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
▪ DTL =
PBT CF/MDI/Harsh/13 29
 Total Leverage
▪ To prove DTL = DOL x DFL
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
▪ DOL =
𝑃𝐵𝐼𝑇
PBIT
▪ DFL =
PBT
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 PBIT 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
▪ Therefore DOL * DFL = * = which is DTL
𝑃𝐵𝐼𝑇 PBT 𝑃𝐵𝑇
▪ Thus DTL = DOL x DFL

CF/MDI/Harsh/13 30
 Example
▪ Total Leverage arises from the existence of fixed operating costs and
interest expenses.
▪ Consider the case of a company which currently has revenues of
₹ 500,000(500 units are sold at ₹ 1,000 per unit).
▪ Its variable costs are ₹500 per unit and its fixed operating costs are
₹ 200,000.
▪ Its fixed expenses are ₹30,000 and tax rate is 50%.
▪ It has 10,000 shares outstanding .
▪ The financial profile of the company at two levels of sales 500 units
( current level) and 600( a level 20% higher than current level is in the
next table .

CF/MDI/Harsh/13 31
 Total Leverage
Case 1 Case 2 % Change Case 1 Case 2
Sales Q 500 600 20.0% Quantity Q 500 600
P in rupee 1,000 1,000 Sales=Q*1,000 5,00,000 6,00,000
Revenue P*Q 5,00,000 6,00,000 Variable Cost= 2,50,000 3,00,000
Variable cost per unit V 500 500 Contribution Margin 2,50,000 3,00,000
Variable Operating Cost Q*V 2,50,000 3,00,000 Fixed cost 2,00,000 2,00,000
Fixed Operating Cost f 2,00,000 2,00,000
EBIT=Q(P-V)-f 50,000 1,00,000
Contribution =Revenue -Variable Cost=Q(P-V) 2,50,000 3,00,000
Interest 30,000 30,000
EBIT=Q(P-V)-f 50,000 1,00,000 100.0%
PBT 20,000 70,000
Interest 30,000 30,000
Tax rate (50%) 10,000 35,000
PBT 20,000 70,000 250.0%
Tax 10,000 35,000 PAT 10,000 35,000
PAT 10,000 35,000 Number of shares 10,000 10,000
Number of share 10,000 10,000 EPS 1 3.5
EPS 1 3.5 Operating Leverage 5 3
DOL= Contribution/EBIT 5 3 66.7% Financial Leverage 2.5 1.4
DFL =EBIT/PBT 2.5 1.4 75.0%
TOL=DOL*DFL 12.5 4.3 191.7% Total Leverage 12.5 4.3

CF/MDI/Harsh/13 32
 Application of Total Leverage
▪ DTL measures % change in EPS which results from 1% change in Q.
▪ It helps in understanding:
▪ Change in EPS
▪ Measuring Total Risk
▪ DTL captures total risk up to some extent since it measures change in EPS from its forecast
value for given value of Q.
▪ The larger DTL implies greater variation in standard deviation around forecasted value of
EPS.

CF/MDI/Harsh/13 33
 Financial Leverage: EPS & ROE Analysis
▪ How does EPS &ROE(Return on Equity) effect Financial Leverage?
▪ Two Plans- Assume
▪ EBIT is constant
▪ EBIT varies

PAT (EBIT−I)(1−T)
▪ EPS= =
N N

PAT (EBIT−I)(1−T)
▪ ROE= =
Value of Equity E

CF/MDI/Harsh/13 34
 EBIT- EPS Analysis

▪ To understand how sensitive is EPS to change in EBIT following are

examples of two different financing alternatives.
▪ The relationship between EBIT and EPS is:
(EBIT – I) (1 – T)
EPS =
N
▪ Where EPS is Earning Per Share, EBIT is Earning Before Interest and
Tax, I is Interest burden and T is tax rate.

CF/MDI/Harsh/13 35
 Analyzing Alternative Financial Plans: Constant EBIT
▪ Let the total expected investment in a firm is ₹ 500,000
▪ The firm is expecting before tax return of 24%
▪ Thus EBIT=24%* ₹ 500,000= ₹ 120,000
▪ The firm is considering two alternative financial plans:
▪ Either to raise the entire funds by issuing 50,000 ordinary shares at ₹10 per share, or
▪ To raise ₹ 250,000 by issuing 25,000 ordinary shares at ₹ 10 per share and borrow
₹ 250,000 at 15 per cent rate of interest.
▪ The tax rate is 50%
▪ What are the effects of above two alternative plans on share holders
earnings?

CF/MDI/Harsh/13 36
Effect of Financial Plan on EPS & ROE: Constant EBIT
Effect of Financial Plan on EPS & RPE: Constant EBIT
Financial Plan
All Equity Debt-Equity
1 EBIT ₹ 1,20,000 ₹ 1,20,000
2 Less Interest I ₹0 ₹ 37,500
3 PBT (Profit Before Tax) EBIT-I ₹ 1,20,000 ₹ 82,500
4 Less Tax T ₹ 60,000 ₹ 41,250
5 PAT(Profit After Tax) (EBIT-I)*(I-T) ₹ 60,000 ₹ 41,250
6 Total Earning of Investor PAT+I ₹ 60,000 ₹ 78,750
7 Number of Outstanding Shares N 50,000 25,000
8 EPS=PAT/N (EBIT-I)*(I-T)/N 1.20 1.65
9 ROE PAT/E 12.0% 16.5%

Investment ₹ 5,00,000
EBIT=24% Invetment ₹ 1,20,000
1 Number of Ordinary Shares 50,000
2 Number of Ordinary Shares 25,000
Debt @15% ₹ 2,50,000
3 Tax 50%

CF/MDI/Harsh/13 37
 Inference
▪ Impact of Financial Leverage is quite significant when D= ₹250,000 the
EPS increases from 1.2 to 1.65 an increase of 37.5%
▪ The ROE has also increased by 37.5%

CF/MDI/Harsh/13 38
 Inference
▪ EPS under the debt equity plan is greater.(1.65 in comparison to 1.2)
▪ As the firm borrows half of its fund at a cost 15% less than its rate of
return on total investment of 24%
▪ Thus it pays a 15% (or 7.5% after tax ) interest on the debt of ₹250,000
while earns a return of 24%(or 12% after tax) .The difference
9%(or4.5%after tax) adds to the share holders without any investment.
▪ The gain due to financial leverage is ₹ 22,500 before tax or ₹ 11,250
after tax.

CF/MDI/Harsh/13 39
 Interest Tax Shield
▪ The interest charges are tax deductible and, therefore, provides tax shield,
which increases the earnings of the shareholders.
▪ Interest Tax Shield=Tax Rate*Interest
▪ Total earnings are more by ₹ 78,750- ₹ 60,000= ₹ 18,700 under debt equity
plan and is equal to the tax shield.
Interest Tax Shield=0.5* ₹ 37,5000 = ₹ 18,700
▪ Thus tax deducted on interest charges makes debt in the capital structure
beneficial to the firm.

CF/MDI/Harsh/13 40
Effect of Financial Plan on EPS & ROE: Constant EBIT

Financial Plan
All Equity Debt-Equity Debt-Equity All Equity Debt-Equity Debt-Equity
1 0.5:0.5 0.75:0.25 1 0.5:0.5 0.75:0.25
24% 24% 24% 12% 12% 12%
1 EBIT 120000 120000 120000 60,000 60,000 60,000
2 Less Interest I 0 37500 56250 0 37500 56250
3 PBT (Profit Before Tax) EBIT-I 120000 82500 63750 60,000 22,500 3,750
4 Less Tax T 60000 41250 31875 30,000 11250 1875
5 PAT(Profit After Tax) (EBIT-I)*(I-T) 60000 41250 31875 30,000 11,250 1,875
6 Total Earning of Investor PAT+I 60000 78750 88125 30,000 48,750 58,125
7 Number of Outstanding Shares
N 50000 25000 12500 50,000 25000 12500
8 EPS=PAT/N (EBIT-I)*(I-T)/N 1.2 1.65 2.55 0.6 0.45 0.15
9 ROE PAT/E 12.00% 16.50% 25.50% 6.00% 4.50% 1.50%

CF/MDI/Harsh/13 41
 Inference
▪ Under 75% Debt & 25% Equity & EBIT=24% of investment
▪ EPS=2.55,ROE=25.5%
▪ EPS increases from ₹1.2 to ₹ 2.55,which is more than double
▪ Thus more Debt larger EPS & ROE
▪ Assume EBIT=12% of investment
▪ Under total Equity plan
▪ EPS= ₹0.6,ROE=6%
▪ Under 50% Debt
▪ EPS= ₹0.45,ROE=4.5%
▪ Under 75% Debt & 25% Equity
▪ EPS= ₹0.15,ROE=1.5%

CF/MDI/Harsh/13 42
 Inference
▪ Thus if firm’s rate of return on total fund is less than cost of debt, the effect
of financial leverage is unfavorable(as D ↑,EPS&ROE↓)
▪ The firm pays 15% on debt and earns 12% on the fund employed. The share
holder will meet deficit of 3%. EPS&ROE↓
▪ If ROI=cost of debt there will be no benefit
▪ Thus the financial leverage will have a favorable impact on EPS & ROE when
firms returns on investment is greater than interest cost of debt.
[ROI>Interest on Debt ]
▪ The impact will be unfavorable if ROI<Interest on Debt
▪ Thus the Effect of Leverage on ROE and EPS is given in the table below:
Favorable ROI>I
Unfavorable ROI<I
Neutral ROI=I
CF/MDI/Harsh/13 43
Thanks

CF/MDI/Harsh/13 44