Capital Structure Final

7/31/2019 Capital Structure Final

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Capital StructureBy:Akhil SardaVishwak KasturiAshwinDishaPrabhasChitrasenShabya


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Contents

Definition Concept of Optimal Capital Structure Significance of Capital Structure Features of Appropriate Capital Structure Elements of Capital Structure Determinants of Capital Structure Approaches to establish Capital Structure Evaluation of Capital Structure


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DEFINITION The permanent long-term financing of a company

including long term debt, common stock andpreferred stock and retained earnings. Its is differentfrom financial structure which includes short termdebt and accounts payable.

Debt comes in the form of bond issues or long-termnotes payable, whereas equity is classified ascommon stock, preferred stock, or retained earnings.

The capital structure is the firm's various sources offunds used to finance its overall operations andgrowth.

The capital structure of a business enterprise shouldbe ideal , that is according to the requirement of the

business enterprise.


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CapitalStructure

Balance Sheet

Current Current

Assets Liabilities

Debt

Fixed Preference

Assets hares

Ordinary

shares


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A company has equity shares of RS. 5,00,000 andreserves and surplus RS. 2,00,000 and Debentures ofRS. 3,00,000. The total long term capital orcapitalization is RS. 10,00,000.and the capital structureof the firm or the mix of capitalization consists equity ,retained earnings and debentures.


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The capital structure that minimizes the firm's cost ofcapital and thereby maximizes the value of the firm.

The optimal capital structure is obtained when themarket value per share is at maximum or theaverage cost is minimum.

The determination of capital structure is formidabletask because a no. of factors influence the capitalstructure of the company.


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It is concerned with the formulation and designing ofproper capital structure .

The most important decision of any company isinvolved in the formulation of an appropriate capitalstructure.

Capital structure will maximize the earning per shareof shareholders.

The design of the capital structure of a company hassome bearing on the profitability and influence on therisk and return of the shareholders.


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A conservative policy may deprive the firm of itsbenefits in terms of magnifying the rate of return ofits equity shareholder.

This is concerned with the determination of debt-equity combination.

If capital structure is appropriate it may improve theand solvency position of the company.


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The cost of capital should be minimum. The debt should be in limits. It should be flexible and adoptable. It should not dilute the control of the company.


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Firms should establish a standard debt- equityratio for their capital structure.

Interest payments may be based on fixed or

floating rates of interest. It should also keep in view theterms and conditions laid down in the loan agreementsor debt instruments.


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Securities differ in case of maturities and alsopriority of payments.

In recent times, companies are allowed tomobilize funds from overseas markets .

Innovation has made the securities moreattractive to investors and reduces cost of capital to thecompany.

Financial markets have different segments.


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Companiesexperiencing variation in their net operating incomerely more on equity than debt and others with stableearnings add more debt.

For retaining control, companies shouldavoid the issue of new equity shares.

Capital market conditioninfluence the capital structure of a company.


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Government regulationsinfluence the financing pattern of a company throughlegislation.

The attitude ofmanagement towards risks plays a vital role inshaping the capital structure plan.

It is a important factor whichformulate the capital structure.


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The capital structure must be flexibleand have debt reserve capacity .

Influences the availabilityof funds from different sources.

Financial leverage effects onEPS, is one of the important factor in capitalstructure planning. High leverage results in high EPSand vice versa.


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for analyzing the impact of debt on

EPS

for determining the impact of debt

on the share holders value

for analyzing the firms ability toservice debt


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It refers to that EBIT level at which EPS remains thesame irrespective of different alternatives of debtequity mix.

At this level of EBIT, the rate of return on capitalemployed is equal to the cost of debt and this is also

known as break-even level of EBIT for alternativefinancial plans.


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Q.1. Suppose a firm is unlevered consistingof 1 lacs ordinary shares of Rs. 10 each.The firm wants to raise Rs. 2,50,000 tofinance its investments and is consideringtwo alternative methods of financing:

a. To issue 25,000 ordinary shares atRs. 10 each

b. To borrow Rs. 2,50,000 at 8%interest rate.

If the firms earnings beforeinterest and taxes after additional

investment are Rs. 3,12,500 and

the tax rate is 50%. What is the

effect of alternatives on EPS?

Financial Plan

Debt-equity(Rs)

All-equity(Rs)

1. Earnings before interest and taxes,

EBIT

312500 312500

2. Less: interest, INT 20000 0

3. Profit before taxes, PBT = EBIT INT

292500 312500

4. Less: Taxes, T (EBIT INT ) 146250 156250

5. Profit after taxes, PAT = (EBIT

INT) (1

T)

146250 156250

6.Less:preference dividend 0 0

7.Earning available to ordinaryshareholders

146250 156250

8.Shares outstanding 100000 125000

9. EPS 1.46 1.25


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Determines the impact of debt on the shareholdersvalue

High debt increases the cost of financial distress &agency cost

Trade off between tax shield and cost of financialdistress & agency cost

Firm should employ debt to the point the marginal

benefits & costs are equal


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Business

Cash In

Customers

Products / Services

Cash out

PayrollInventoryUtilitiesRentTaxesInterestsLoansEtc.

Equity and/or

Debt financing


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In determining a firms target capital structure, a keyissue is the firms ability to service its debt.

The focus of this analysis is also on the risk of cashinsolvency-the probability of running out of the cashgiven a particular amount of debt in the capitalstructure

This analysis is based on a through cash flow analysisand not on rules of thumb based on various coverageratios


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This type of analysis is done through thepreparation of proforma cash flow statements. It is grouped into three kinds.

It is generated from the main operations of thebusiness and determined from the projected financialstatements.

Normally capital expenditure and workingcapital changes included .

Payment of interest and dividends andrepayment of debt, lease rentals and other financialcharges are included.


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Capital structure is evaluated from different

points of view. In the view of shareholders return, risk and value

are most important. From the strategic point of view, flexibility is

important.

A sound capital structure must posses all thesefactors.


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The debt equity mix should be within the debt

capacity. In other words the capital structure should beflexible .

Usage of more debt adds to the profitability of theshareholders. It also adds financial risk to the company.

The objective of the capital structure is to minimize

the cost and maximize the market value of the shares.


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The capital structure should not result in partingwith the control of the company.

While designing a capital structure, the current andfuture capital market condition should be taken into account .


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EBITLess-Interest

Net Income(NI)Ke

Value of Equity(S)

Value of Debt(D)

V(S+D)

Ko(EBIT/V)*100

45000045000

405000.12

3375000

450000

3825000

45000060000

390000.125

3120000

600000

3720000

45000082500

367500.135

2722222

750000

3472222

450000108000

342000.15

2280000

900000

3180000

450000147000

303000.18

1683333

1050000

2733333


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Bibliography

I. M.Pandey


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Capital Structure Final

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