Capital structure

Capital Structure

• Meaning of Capital Structure

– The makeup of a firms capitalization

– The mix of the different sources of long term funds in the total capital of the company

• Equity

• Preference shares

• Debentures

• Retained earnings

Capital Structure

• Capital Can be raised by two means

– Ownership securities

• Equity Shares

• Preference Shares

– Creditor ship Securities

• Debentures/Bonds

Capital Structure

• Difference between Capital Structure and Financial Structure

– Financial structure

• It includes both the long term and short term sources of funds

– Capital Structure

• Includes the long term sources of funds

– Capital structure is a part of financial sturcture

–

Capital Structure

• Pattern of Capital Structure

– All equity Shares

– Equity and Preference Shares

– Equity Shares and Debentures

– Equity Shares ,Debentures and preference shares

• In General we can say that capital structure is the mix of DEBT and EQUITY

• So finding an optimal capital structure is finding the right mix of Debt and Equity.Why?

Capital Structure

• Mix of D/E has a great impact on the Earnings of the company

• Maximizing the Earnings is the objective of the organization

• So the task is to find that ratio of D/E where the EPS is maximized

–

Capital Structure

• How to Write the Earning Statement of the Company

• A company has following data• Sales = Rs 1,00,000

• Cost= Rs 40,000

• Debt payment = RS 5000

• Dividend to Preference Share Holders = Rs 20,000

• No of Equity Shares = Rs 1000

• Find the EPS( Earning Per Share) for the company?

Earnings Statement of the COMPANY

1 Sales 1,00,000

2 Cost 40,000

3 Operating Profit (1-2)Earning Before Interest and Tax

(EBIT)

Rs 60,000

4 Less Interest on the Debentures 5000

5 EBT (Earnings before Tax) (3-4) Rs 55000

6 Less Tax@50% 27500

7 Earnings after TaxOrProfit After Tax (PAT) (5-6)

RS 27500

8 Less Dividend to Pref. Share Holders RS 20,000

9 Earnings Available to Equity Share Holders (EATES) (7-8)

RS 7500

10 n ( No of Shares=1000) , EPS 7500/1000 = Rs 7.5

Capital Structure

• Let There be company having a share capital of Rs 1,00,000 divided in to the share of Rs 10 each.. Company's present EBIT is Rs 40,000 .Tax rate is 50%.

• Find out the EPS for this company?

• The company wants to expand and this expansion requires an investment of Rs 50,000 Suppose that company's EBIT will not change with this new expansion. The company is considering following expansion plans1. Issue 5,000 equity shares of Rs 10 each

OR

Issue 5000 preference shares, interest 12%,of Rs 10 each

OR

Issue bonds of Rs 5000 of 10% interest of Face Value Rs 10

• Which proposed capital structure the company should accept if the EBIT of the company will not change from the present value

OPTION 1 (All Equity)

3 (EBIT) 40,000

4 Less Interest on the Debentures NIL

5 EBT (Earnings before Tax) (3-4) 40,000

6 Less Tax@50% 20,000


20,000

8 Less Dividend to Pref. Share Holders Nil


20,000

10 n ( No of Shares=10000+ 5000) , EPS Rs 1.33

3 (EBIT) 40,000

4 Less Interest on the Debentures NIL

5 EBT (Earnings before Tax) (3-4 40,000

6 Less Tax@50% 20,000


20,000

8 Less Dividend to Pref. Share Holders 6000


14000

10 n ( No of Equity Shares=10000) , EPS Rs 1.40

OPTION 3 Debentures

(EBIT) 40,000

Less Interest on the Debentures 5000

EBT (Earnings before Tax) (3-4 35,000

Less Tax@50% 17500

Earnings after TaxOrProfit After Tax (PAT) (5-6)

17500

Less Dividend to Pref. Share Holders Nil

Earnings Available to Equity Share Holders (EATES) (7-8)

Rs 17500

n ( No of Shares=10000) , EPS Rs 1.75

Present EPS With All Equity With PrefShares

With Debentures

Rs 2 Rs 1.33 Rs 1.40 Rs 1.75

Reduction in the EPS is Minimum in the case of Debentures

so the Option of capital structure with Debenture is Best

Capital Structure

• Let There be company having a share capital of Rs 1,00,000 divided in to the share of Rs 10 each. The company wants to expand and this expansion requires an investment of Rs 50,000. Company's present EBIT is Rs 40,000 and suppose that company's EBIT will increase to Rs 50,000. The company is considering following expansion plans

1. Issue 5,000 equity shares or Rs 10 each

OR

Issue 5000 preference shares, interest 12%,of Rs 10 each

OR

Issue bonds of Rs 5000 of 10% interest

• Which proposed capital structure the company should accept on the basis of % increase in EPS criteria

OPTION 1 (All Equity)

(EBIT) 50,000

Less Interest on the Debentures NIL


Less Tax@50% 25,000


25,000



25,000

n ( No of Shares=10000+ 5000) , EPS Rs 1.67

OPTION -2 Preference Shares

(EBIT) 50,000

Less Interest on the Debentures NIL


Less Tax@50% 25,000


25,000

Less Dividend to Pref. Share Holders 6000


19000

n ( No of Equity Shares=10000) , EPS Rs 1.90

OPTION 3 Debentures

(EBIT) 50,000

Less Interest on the Debentures 5000


Less Tax@50% 22500


22500



Rs 22500

n ( No of Shares=10000) , EPS Rs 2.25


With Debentures

Rs 2 Rs 1.67 Rs 1.90 Rs 2.25

Option of capital structure with Debenture is Best

Capital Structure

• The company having XYZ has a capital structure as follows

1. Equity shares of Rs 100 each = Rs 20 Lakhs

2. Preference shares @9% = Rs 12 Lakhs

3. Debentures @ 7% = Rs 8 Lakhs

4. Retained Earnings = 10 Lakhs

– The company earns 12% on its capital Employed(ROCE)

– Income tax rate is 50%.

– Find the EPS for the company?

Capital Structure

• What will be the starting point?

• EBIT--- The first figure in the Earning Statement

• EBIT is nothing but earnings– Compnay is earning @12% on the capital employed

• 12% of Rs 50 Lakhs = Rs 6,00,000

Earning Statement of Company

(EBIT) 12% on capital (50,00,000) 6,00,000

Less Interest on the Debentures 56,000

EBT (Earnings before Tax) (3-4 5,44,000

Less Tax@50% 2,72,000


2,72,000

Less Dividend to Pref. Share Holders 1,08,000


Rs 1,64,000

n ( No of Shares=20,000) , EPS Rs 8.20

Capital Structure

• The same company is thinking for an additional plant for which it needs Rs 25 lakhs. The following alternatives are available to the company for financing

1. Alternative 11. 20000 Equity shares of Rs 125.0 each

2. Alternative 21. Preference shares @10%

3. Alternative3 1. Debentures @ 8%

– Which Financing Option would you recommend? The ROCE for the company remains the same at 12%

Equity Option

(EBIT) 12% on capital 9,00,0000

Less Interest on the Debentures (old) 56,000


Less Tax@50% 4,22,000


4,22,000

Less Dividend to Pref. Share Holders (old) 1,08,000


Rs 3,14,000


Preference Share Option

(EBIT) 12% on capital 9,00,0000

Less Interest on the Debentures (old) 56,000


Less Tax@50% 4,22,000


4,22,000

Less Dividend to Pref. Share Holders (old)Dividend to Pref. Share Holders (New)

Total

1,08,0002,50,000


Rs 64,000



With Debentures

Rs 8.20 Rs 7.85 Rs 3.20 Rs 10.70

Option of capital structure with Debenture or financing through

Debt is the Best

Example

A company needs Rs 60,00,000 for the installation of new factory which is expected to earn an EBIT of Rs 10,00,000 per annum. The company has the objective of maximizing the EPS. The company is considering the possibility of issuing equity shares plus raising a debt of Rs 10,00,000 or Rs 30,00,000 and or Rs 50,00,000.The current market price of the share is Rs 40 per share and will drop to Rs 25 if the borrowings exceed Rs 37,50,000.The cost of borrowing is as under1. Up to Rs 12,50,000 10%

2. 12,25,000 - 31,25,000 14%

3. 31,25,000 – 50,00,000 16%

Assuming the tax rate of 50% find out the EPS under each option. Which option is advisable and why?

Calculating Indifference Point

EBIT X

Less Interest on Bonds I

EBT (Earnings before Tax) (3-4 X-I

Less Tax@T% T x (X-I)

Earnings after TaxOrProfit After Tax (PAT)

(X-I)-T(X-I) = (X-I)( 1-T)

Less Dividend to Pref. Share Holders PD

Earnings Available to Equity Share Holders (EATES)

(X-I)( 1-T)-PD

n ( No of Shares) , EPS (X-I)( 1-T)-PD------------------

n

Capital Structure

– SO One can Write EPS as follows

– EPS = (X-I)(1-T)- PD

n

Where

• X= EBIT

• I= interest paid to Debenture Holders

• T= Tax Rate

• PD= Dividend paid to Preference Share Holders

• n = No of Equity shares in the capital structure

Capital Structure

– Let there be 2 capital structures with EPS1 and EPS2

– Let EPS1 = EPS2 at some value of EBIT value = X

–This is called the indifference point

(X-I1)( 1-T)-PD1 = (X-I2)( 1-T)-PD2

n1 n2

Capital Structure 1 Capital Structure 1

EPS1 EPS2

(X1-I1)( 1-T)-PD1

------------------n1

(X2-I2)( 1-T)-PD2

------------------n2

Capital Structure

• Example

• The company is thinking for an additional plant for which it needs Rs 150 lakhs. The following alternatives are available to the company for financing

1. D/E ration of Rs 2:1,with equity financing by issuing shares @ Rs 1000 per share

2. All equity financing of 15000 share@ RS 1000

Calculate EBIT at indifference point. Interest rate on term loan is 12%

Capital Structure

(X1-I1)( 1-T)-PD1 = (X2-I2)( 1-T)-PD2

n1 n2

• Option 1= all equity with 15000 share@100 each

• Option 2 = D/E is 2:1• Debt = Rs 100 Lakhs

• Equity = Rs 50 Lakhs ( 5000 shares of Rs 1000 each)

Capital Structure

– Option 1 (all equity)

• Interest = 0

• Pd = 0

• n = 15,000

– Option 2 (D/E)

• Interest = 12 Lakh

• Pd = 0

• n = 5000

(X-0)(1-.50)-0 = (X-12)(1-.50)-0

15 5

X= RS 18 Lakhs which is the EBIT at the point of indifference

Capital Structure

• Example 2

• The company is thinking for an additional plant for which it needs Rs 50 lakhs. The following alternatives are available to the company for financing

1. Sale of debenture @ 10%

2. All equity financing of share@ RS 50

Current capital structure of the company is as follows

• 10 Lakh ordinary share and no debt

– Calculate EBIT at indifference point, tax rate is @50%

Capital Structure

• Relevance of Calculations

– If expected EBIT > EBIT at indifference point Debt financing is beneficial

– If expected EBIT < EBIT at indifference point Equityfinancing is beneficial

• Next Class Theories of Capital Structure

Capital structure

Economy & Finance

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