1.0 Module 1_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 Equity: Funds contributed by

is that you promise to repay. owners with no promise of
If you fail to make those repayment.
payments, you lose control
of your business.
 Residual Claim
• Fixed Claim  Not Tax Deductible
• Tax Deductible  Lowest Priority In Financial
• High Priority in Financial Trouble
Trouble  Infinite
• Fixed Maturity  Management Control
• No Management Control
DEBT – COSTS & BENEFITS
Benefits Costs
 Tax Benefits:  Agency Cost:
 you are allowed to deduct interest  When you lend money to a business, you are
expenses from your income to arrive at allowing the stockholders to use that money in
taxable income. This reduces your taxes. the course of running that business. Stockholders
When you use equity, you are not interests are diﬀerent from your interests,
allowed to deduct payments to equity because You (as lender) are interested in getting
your money back but Stockholders are interested
in maximizing their wealth. This leads to conflict
 Discipline to Management: of interest which has to be resolved at every
 If you are managers of a firm with no action by BOD
debt, and you generate high income and
cash flows each year, you tend to  Loss of Flexibility:
become complacent. The complacency  When a firm borrows up to its capacity, it loses
can lead to ineﬃciency and investing in the flexibility of financing future projects with debt
poor projects. There is little or no cost
borne by the managers. Forcing such a  Bankruptcy Cost :
firm to borrow money can be an antidote  The probability of bankruptcy depends on
to the complacency. 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 • Stock price level
Service Coverage Ratio
• Expected Return
• Expected Growth rate
• Cost of financing
CAPITAL STRUCTURE THEORIES
• Trading on Equity Theory

• Pecking order theory
• Static Trade Off Theory
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 profi tability and debt ratio
within an industry.
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.
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

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
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

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CAPITAL STRUCTURE

• The objective of a firm should be directed towards the

• The proportion of funds contributed by different sources is

• Thus managers aim to identify the optimal capital structure

• Value of firm(EV) = EBIT

• The capital structure should be planned generally, keeping in

• While developing an appropriate capital structure for its

Debt: The essence of debt Equity: Funds contributed by

• Company Profile: Size , Nature • Tax rate

• Trading on Equity Theory

• The―pecking order theory is based on the assertion that

Trading on equity is also sometimes referred to as financial leverage or

• EBIT-EPS Analysis (also MPS)

The point of indifference can also be

• Benchmark to measure the cash-producing ability of entity

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