Capital structure

Capital Structure Defined

• The term capital structure is used to represent the proportionate relationship between debt, preference and equity shares on a firm’s balance sheet.

• 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

Questions while Making the Financing Decision

• How should the investment project be financed?• Does the way in which the investment projects are

financed matter?• 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?

OPTIMUM CAPITAL STRUCTURE

• Optimum capital structure is the capital structure at which the market value per share is maximum and the cost of capital is minimum.

PATTERNS / FORMS OF CAPITAL STRUCTURE

Following are the forms of capital structure.

• Complete equity share capital;

• Different proportions of equity and preference share capital;

• Different proportions of equity and debenture (debt) capital and

• Different proportions of equity, preference and debenture (debt) capital.

APPROACHES TO DETERMINE APPROPRIATE CAPITAL

STRUCTURE• EBI T – EPS Approach – This approach is

helpful to analyze the impact of debt on earnings per share.

• Valuation Approach – This approach determines the impact of debt use on the share holders value and

• Cash Flow Approach - This approach analyses the firm’s debt service capacity

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

Operating Leverage

• operating leverage is caused due to fixed operating expenses in the firm. 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.

A firm sells products for Rs. 100 per unit, has variable operating cost of Rs. 50 per unit and fixed operating cost of Rs. 50000 per year. Show the various levels of EBIT that would results from the sale of (i) 1000 units, (ii) 2000 units and (iii) 3000 units.

How to calculate OL?

• The degree of operating leverage may be defined as the change in the percentage of operating income (EBIT), for the change in percentage of sales revenue. The degree of operating leverage at any level of output is arrived at by dividing the percentage change in EBIT with percentage change in sales. That is

Degree of Operating Leverage (DOL) = Percentage change in EBIT / Percentage change in sales

Or DOL=Contribution / Operating profit (EBIT)

Impact of OL

Operating leverage may be favorable or unfavorable. High degree of operating leverage indicates that high degree of risk. It is good when revenues are rising and bad when they are falling.

Operating risk (business risk) is the risk of the firm not being able to cover its fixed operating costs. The larger the magnitude, the larger the volume of sales required to cover all fixed costs.

• Application of Operating Leverage• It is helpful to know how operating profit (EBIT) would change with a

given change in units produced.• It will helpful in measuring business risk.

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.

• In other words, financial leverage may be defined as the payment of fixed rate of interest for the use of fixed interest bearing securities to magnify the rate of return on equity shares

• The financial manager of the Hypothetical Ltd. expects that its EBIT in the current year would amount to Rs. 10000. The firm has 5 per cent bonds aggregating Rs. 40000, while the 10 percent preference shares amount to Rs. 20000. what would be the earning per share ? Assuming the EBIT being (i) Rs. 6000, and (ii) Rs. 14000, how would he EPS be affected. The firm can be assumed to be in the 35 percent tax bracket. The no. of outstanding shares is 1000.

Financial leverage in computed by the following formula

Degree of financial leverage (DFL)= Percentage change in EPS divided by Percentage change in EBIT

tDp

IEBIT

EBITFL

1

Impact of FL

• Financial leverage may be positive or negative. favorable leverage occurs when the firm earns more on the assets purchased with the funds, than the fixed cost of their use and vice versa. Higher the degree of financial leverage leads to high financial risk.

• The financial risk refers to the risk of the firm not being able to cover its fixed financial costs. Hence, financial manager should take into consideration the level of EBIT and fixed charges while preparing the firm’s financial plan.

EBIT-EPS analysis• Suppose a firm has a capital structure exclusively

comprising of ordinary shares amounting to Rs. 1000000. the firm now wishes to raise additional Rs. 10 lac for expansion. The firm has four alternative financial plans:

1. It can raiser the entire amount in the form of equity capital.

2. It can raise 50 percent as equity capital and 50 percent as 5% debentures.

3. It can raise the entire amount as 6% debentures.4. It can raise as 50 percent as equity capital and 50 % as

preference capital.Further assume that the existing EBIT are Rs. 120000, the tax rate is 35 percent, outstanding ordinary shares 10000 and the market price per share is Rs. 100 under all the four alternatives.

What financing plan should the firm accept?

Financial break even point

• It is the level of EBIT that a firm must earn to pay its fixed financial charges.

Financial BEP= Interest + Dp

(1-t)

Indifference point

• It is the EBIT level at which the EPS is same for two alternative financial plans. It is beyond this point only, the benefits of financial leverage accrues with respect to EPS.

The financial manager of a company has formulated following financial plans to finance Rs. 30 lac required to implement various capital budgeting projects:

(i) Either equity capital of Rs. 30 lac or Rs. 15lac 10% debenture and Rs. 15 Lac equity.

You are required to determine the indifference point for each financial plan , assuming 35 per cent corporate tax rate and the face value of equity shares as Rs. 100.

Combined Leverage

Or

= Contribution

EBIT-I-Dp/(1-t)

OR

= FL x OL

sales Change %

EPSin change %

EBITin Change %

EPSin Change %*

salesin change %

EBITin Change %CL

• 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:

Impact of CL

• The combined leverage can work in both directions. It is favorable if sales increase and unfavorable when sales decrease.

• This is because the change in sales results in more than proportion returns in the form of EPS. Financial leverage and operating leverage are something like double-edged sword.

• They have tremendous acceleration or deceleration effects on EBIT and EPS. A right combination of these leverage is blessing for corporate growth, while an improper combination may prove as a curse.

Assignment for student

• Find out the 10 NSE listed Companies and calculate Financial , combined and Operation leverage and Interpret the same. The sources of information are

www.nseindia.com

Prowess data base

Firms’ websites

Debt-equity Mix and the Value of the Firm

• Capital structure theories: – Net income (NI) approach. – Net operating income (NOI) approach.– MM hypothesis with and without

corporate tax.– Traditional approach

ASSUMPTION OF CAPITAL STRUCTURE THEORIES

There are only two sources of funds i.e.: debt and equity.• The total assets of the company are given and do no

change.• The total financing remains constant. The firm can

change the degree of leverage either by selling the shares and retiring debt or by issuing debt and redeeming equity.

• Operating profits (EBIT) are not expected to grow.• All the investors are assumed to have the same

expectation about the future profits.• Business risk is constant over time and assumed to be

independent of its capital structure and financial risk.• Corporate tax does not exit.• The company has infinite life.• Dividend payout ratio = 100%.

Net Income (NI) Approach

• According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt.

• This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach