CHAPTER 15: CAPITAL CA CS HARISH A.

MATHARIYA

STRUCTURE
9970668807

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545

“Capital Structure of a company refers to the composition or make up of its Company के Capital में ककतना
Equity होना And ककतना Debt Factor
capitalization and it includes all long-term capital resources”.
इसका Decission लेते है

TYPE OF CAPITAL STRUCTURE

HORIZONTAL CS VERTICAL CS PYRAMID SHAPED CS INVERTED PYRAMID

SHAPED CS

• Zero debt component • Very High debt and pref. • Large equity and • High debt component and
• CS consist all equity or Share Capital component retained earning since, Ke small equity component
retained earnings • Low equity component < Kd • Ever increasing
• This Structure is Stable • Increases financial risky • Less risky component of debt
• More expensive • Highly levered • Low debt • Less stable
• No leverage • Low stability • Indicative of risk averse • High risk
• Lateral growth firm • Vulnerable to hostile conservative firms. • Vulnerable to collapse
takeover
• K e > Kd

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.1
 SIGNIFICANCE OF CAPITAL STRUCTURE
Existing Affects Desired Affects Payout
C.S D-E mix policy
It reflects It is an indicator of It acts as a tax It helps to
the firm the risk profile of management brighten the

➯
strategy the firm tool image of the firm
To reach at desired C.S, consider:
Risk Return
Risk Cost Control
This will impact on cost of capital funds
Equity Low risk More expense Dilute
CS is mix of long term scours of funds:
Loan / debenture High risk Cheaper No-Dilution
Equity 30 50 90
Financing Decision Preference share 20 30 10
Decision relating to
➯ ➯ ➯

Internal purchase of F.A Deb 30 20 -

Funds (retained • Expansion Loan 20 - -
Regd. For capital budgeting
earning) • Diversification

➯
• Modernization Try to reach most
Need to raise funds • Replacement of PSH Optimum CS appropriation
External
Debts/IPO/right Now, we have to decide how much Maximize value
Minimize cost of
share money to raise from which source Proportion of of firm
capital
➯

long term
This is capital structure decision finance

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.2
 ATTRIBUTES OF A WELL PLANNED CAPITAL STRUCTURE

Return Risk Flexibility Capacity Control

FACTORS INFLUENCING CAPITAL STRUCTURE

CASH FLOW INTEREST DEBT SERVICE RETURN ON

POSITION : COVERAGE RATIO- COVERAGE RATIO- INVESTMENT-ROI COST OF DEBT : TAX RATE
ICR: DSCR
• Cashflow depend • This ratio is use to • This shows cash • The greater return • It shows the • Tax affect cost of
on availability of check the debt flow position of co. on investment of a capacity of co to capital.
cash out of capital capacity of co . • Capacity of co to company increases bare cost of debt.
structure. • It shows how many payback debt. its capacity to
time EBIT is able to utilize more debt
pay interest capital.

COST OF EQUITY : FLOATING COST : RISK FLEXIBILITY CONTROL REGULATORY

CONSIDERATION: FRAMEWORK

• Use of debt • Cost of issuing • There are two • CS shall be • Equity share dilute • Govt policies can
capital can security also types of risks in flexible such as, it the control also influence the
influence the cost influence CS …FC business – can be increased / • Less dilution of CS of co
of equity capital of equity more • 1. Operating or decreased as will control in case of
than Debt cap Business Risk debt capital
• 2. Financial Risk

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.3
 Component of financial risk
3. V = Value of firm
Risk of cash insolvency Risk of Variation in EPS Risk in cost of capital V=E+D

Firm does not have liquidity to 4. Ko = overall cost of capital

pay its liability ∴ Earning will fluctuate ∴ Financial risk ↑
= wt. Avg. cost of capital
∴ Excessive use of debt Cause excess use of debt ∴ Lender नालायक हो जायगा = Overall expectation of the investor from a business
𝐸𝐵𝐼𝑇
Ko =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑡𝑚
∴ Firm may be Liquidated Firm become uncertain ∴ Interest rate ↑
6. Ko = WACC = (Kd X Wd) (+) (Ke X We)
E.g. ₹ Weight Cost
STOCK MARKET CONDITIONS :
E 100 50% 10%
• Upward and downward trend in Stock market also influence CS of co D 100 50% 8%
CAPITAL STRUCTURE OF OTHER COMPANIES : Ko = (10 X 0.5) + (8 X 0.5)
• CS is influenced by the industry to which a company is related. = 5+ 4 = 9%

SOME IMPORTANT FORMULAE: 5. EBIT or NOI

1. E = Market value of equity
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝐸𝑆𝐻
E= Sales
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖.𝑒. 𝑘𝑒 Desired rate of return (Ke)
E=
1,00,00,000 (-) V.C.
10% 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝐴𝑣𝑙. 𝑡𝑜 𝐸𝑆𝐻 (=) Balance
E = ₹ 10,00,000 ∴ ke = (-) Opt. Fixed cost
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝐸)
(=) EBIT
2. D = Market value of Debt (-) Interest
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 10,00,000 𝐼
D= = = ₹ 1,00,000 ∴ Kd = (=) EBT
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝑖.𝑒. 𝐾𝑑 ) 10% 𝐷
𝐼 (-) TAX
∴ Cost of debt = EAT
𝐷 (𝑖.𝑒.𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.4
 A B C D
Capital Structure Theories EBIT 20 20 20 20

Net Income Net Operating Traditional Modigliani - Investors expectation from the firm remains same
Approach Income Approach Approach Miller Theory I. Capital structure can be altered without any transfer cost

CS THEORIES Divides In 2 Parts

1. NET INCOME APPROACH
C.S influence value of firm
CS influence CS does not influence Specific Assumption:-
Value of firm value of firm
1. No taxation
➩

➩
2. Kd < Ke
A. Net Income Approach (N.I) A. Net Operating Income (NOI)
B. Traditional Theory B. Modigliani & Milter (MM)
3. Kd & Ke remain constant at all level of D/E mix
Approach
GENERAL ASSUMPTION Ko = (Wd x Kd) + (We X Ke)
Total of weight
A. There are only 2 source of funds < Debts & Equity = (4 X 8) + (1 X 10)
B. Total capital firm will remains constant. 5 D E Kd Ke
C. ∴ EBIT – Constant = 8.4% 4: 1 8% 10%
∴ Sales Constant 1: 4 8% 10%
Kd = 1 X 8 + 4 X 10
{EBIT = sales – COGS – Operating Exp.} 3: 2 8% 10%
5
D. Zero retention – 100% payout = 9.6%
E. EBIT (operating profit) = ‘ + ve’
F. Business risk – constant Ko = 3 X 8 + 2 X 10
G. No Taxation – to simplify theory 5
H. No of difference in investors perception = 8.8%

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.5
 4. Use of debt component does not change the risk perception of
investor 2. NET OPERATING INCOME APPROACH
5. Ko Decrease with increase in debt in capital share (logic Kd < Ke) CS have NO influence on value of firm
Assumption
Y
Cost of 1. Kd<Ke
जेसे जेसे Debt
Ke
Capital 2. Kd remain constant
वेसे Ko 3. Ke ↑ with more use of debt Ko
Ke ∴Debt ↑ ∴Ke ↑ ∴Ko ↑ Constant
Ke>Kd Ko = constant
Ko if debt ↑ ∴ Ko ↓ Kd
Kd 4. Ko = constant
Kd<Ke 𝐸𝐵𝐼𝑇 (𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡) X
5. Value of firm = …… (CONSTANT)
𝐾𝑜 (𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡)
6. ∴ conclusion:-
D – E Mix there is no optimum capital share each
THUS; Firm should take max use of debt it will reduce Ko if firm capital share is as goods other C.S

Calculation of value of firm & Ko under NI Approach Calculation of value of equity & Ke (NOI Approach)
Step 1: Determine Market value of Equity:
A. EBIT
EBIT
B. (-) Interest
(-) Interest C. (-) EBT
(=) EBT D. Overall cost of capital (Ko) constant
(÷) Ke 𝐸𝐵𝐼𝑇
𝑬𝑩𝑻
E. Value of firm 𝐾𝑜
(=) market value of equity
𝑲𝒆 F. Value of Debt
𝑰
Step 2: Market Value of debt
𝑲𝒅
G. Value of equity (Value of firm – value of debt)
Step 3: Market value of firm (Step 1+ Step 2) 𝐸𝐵𝑇
𝑬𝑩𝑰𝑻 H. Cost of equity (Ke)
Step 4: Ko = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑭𝒊𝒓𝒎
CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.6
 3. TRADITIONAL APPROACH (Mix of NI & NOI)
As per this theory, there are 3 phases in CS of an entity
COMPARISON BETWEEN – NI & NOZ
1. In both theories Kd<Ke Phase – I Phase – III
Phase – II
(Low amt. of (Excessive use of
2. In both the theories Kd is Constant (Moderate debt)
debt) debt)
3. In NI approach Ke is constant where as in NOI approach Ke
increasing with increase in D/E ratio Kd Constant Constant Increases
4. In NI approach the risk perception of equity investor does Increases @ highest
not change even if firm uses more debt how even, in NOI Ke Constant Increases
rate
approach the risk perception of equity investor change
Decreases Constant
because he thinks that financial risk increases with use of 𝐾𝑑↑
Ko (like N.I. (like NOI Increases
more debt 𝐾𝑒↑
approach) approach)
5. The optimum C.S. is one where the value of firm maximum &
COC is minimum. In NI approach it is possible to reach बहोत ज्यादा debt use करोगे तो Ko ↑
optimum C.S by making maximum use of debt. Nothing is constant
6. In NOI approach value of firm remain constant at all D/E Ko
↑
Ko Ko ↑

↑
mix so no optimum C.S in NOI approach Low Debt Moderate Debt Exercise Debt
7. In NI approach Ko decreases with use of more debt where
As per this theory C.S. influence value of firm and overall capital the firm
as in NOI approach Ko remain constant for all levels of D/E should choose that CS where value of firm is maximum i.e. firm should
mix choose cs in Phase II
NI or NOI ??
Choice is
yours !

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.7
 Chance of Best CS-in Value of firm
Y improved Phase II So Ko 4. MODIGLIANI - MILLER THEORY
• It is like NOI approach
Phase – I Phase – II Phase – III
Ke • Value of firm does not change due to ch. In CS
Like NOI Like NI Worst • There is no optimum CS
• This more detailed than NOI approach
Assumption
Ke Ke 1.
Ko 2. (Same as NOI)
Kd 3.
Ko - constant 4.
Kd 5. Perfect capital Market :
a. Investors are free to buy & sell section (Without any restrictions)
b. No transaction cost
c. Investor have full knowledge of risk & returns of all securities
d. Investor behave rationally
X e. They can borrow without any restrictions
6. Firms can be grouped into “Equivalent Risk class” - SBI, ICICI invest
where RD Infosys TCS Maruti, Hyundai

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.8
Proposition I :The total value of a firm is equal to its
expected operating income divided by the discount CRITICISM OF MM HYPOTHESIS
rate appropriate to its risk class. It is independent of
the degree of leverage (means independent of its • Not possible to satisfy all the assumption in real
capital structure). • MM’s results would hold true only under a
𝑬𝑩𝑰𝑻 particular set of assumptions
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒇𝒊𝒓𝒎 𝑴𝑴 =
𝑲𝒐

Proposition II
The expected yield on equity, Ke is equal to Ko plus a EMPIRICAL EVIDENCE AGAINST MM
premium. This premium is equal to the debt – equity HYPOTHESIS
ratio times the difference between Ko and the yield on • It is a modified version of MM model to control the fall
debt, Kd. This means that as the firm’s use of debt of firm’s value due to excessive use of debt (trade-off
increases its cost of equity also rises, and in a theory)
mathematically precise manner Suggestions: That a certain amount of debt is good
𝑫𝒆𝒃𝒕 That too much debt is bad, and
Ke MM = 𝐾𝑜 + 𝑲𝒐 − 𝑲𝒅 𝑿 That there is an optimal amount of debt for
𝑬𝒒𝒖𝒊𝒕𝒚
every firm.
Proposition III Financing & Investment decision are
independent
CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.9
Financial Break Even Point: Note - In above graph if
1. It is that level of EBIT at which EPS is ‘O’ 1. EBIT is expected to be below EPS indifference point will be
2. It is that level of EBIT which is just sufficient to cover interest and plan I – Highest EPS
preference dividend 2. If EBIT expected to be more than EPS indifference point Plan
Prefernce dividend
3. Financial BEP = interest + II – will be have higher EPS
1 −tax rate
EBIT 3. EPS indifference point will be founded by solving an equation
(+) Interest (later)
(=) EBT 4. Horizontal intersect represent financial ESP for Each plan
(-) Tax
(=) EAT ये EBIT Level पे
(-) Preference dividend दोनो plan का EPS
Earning avl. For ESH ZERO same होगा Which plan to be chosen?
1. If EBIT is expected to be below indifference point – the option
EPS Indifference Point
with lower debt should be chosen, reason being at lower EBIT
1. It Is that level of EBIT at which EPS under 2 financing plans are equal
2. It is also called EPS equivalency point level more interest and debt not advisable
2. If EBIT is expected to be above in indifference – option with
EPS Plan II higher debt be chosen, reason it increases the EPS
Plan I
3. If EBIT is expected to be equal to indifference point any plan
EPS. .. (EPS in difference point)
can be chosen, cause EPS is same

EBIT
.
Financial BEP
.
Financial BEP
.
EPS indifference
of plan I of plan II point

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.10
Calculation of EPS Indifference:
Master formula

Plan 1 = Equity + Debt + Preference share

Plan 2 = Equity + Debt + Preference share
𝑬𝑩𝑰𝑻 −𝑰𝟏 𝟏 −𝒕 𝑷𝑫𝟏 (𝑬𝑩𝑰𝑻 −𝑰𝟐) 𝟏−𝒕 −𝑷𝑫𝟐
FPWLL
=
𝑵𝟏 𝑵𝟐
N = No. of equity shares under respective plan
I = Interest under respective plan
PD = Pref dividend under respective plan

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.11
LEVERAGE
• Leverage, refers to a relationship between two interrelated variables.
• It is useful for risk analysis, As you know business uses fixed cost & because
of excessive use of fixed cost, risk will increase. But, some times businessman
uses fixed cost to increase return
• Sales increase by just 10% but EBIT
increase by 50%
E.g. I II
• Here, magic is FIXED COST
Sales 10,000 11,000 Sales ↑ by 10% • Sales increased, VC increased but FC
(-) V. C. 5,000 5,500 remains constant hence profit increased
more than proportionate change
(=) Contribution 5,000 5,500 • Here we uses FC like a lever to lift
(-) F. C. 4,000 4,000 profit up
Profit (EBIT) 1,000 1,500 But profit ↑ by 50%)
• EBIT increase by 50% but EPS increase
(-) interest 500 500 Interest will be same in by 100%
both case • Here, magic is Interest COST
(=) EBT (Ignore Tax) 500 1,000 • Here interest cost remains constant
hence EPS increased more than
No. of Shares (Lets) No. 100 No. 100
proportionate change
(=) EPS Rs. 5 Rs. 10 EPS increase by 100% • Here we uses Interest like a lever to lift
EPS

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.12
So, Fixed Cost is GOOD or BAD????

• Even if Earning increase, FC remains same - Good

• Even if Earning decrease, FC remains same - Bad

Few examples of financial variable:

• Sales;
• VC;
• FC;
• EBIT;
• Pref. Dividend;
• EBT
• Tax
• EAT
• etc

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.13
 A Support, influence,
resources, or advantage
LEVERAGE to achieve a desired
Definition-“the employment of an asset or fund for which the firm pays a fixed cost or fixed return. outcome.

TYPES OF LEVERAGE
Operational Financial Leverage Combined Leverage
Leverage

❑ Ability of firm to use fixed cost (Fixed ❑ Use Debt to increase profit
operating cost) To magnify effect of change in ❑ Measure the ability of the firm to use ❑ Combines the effect of ‘operating
sale on EBIT fixed financial charges to magnify the leverage’ and ‘financial leverage.
❑ It can be achieved by Exploitation of the effects of change in EBIT on EPS. CL = OL x FL
capacity using maximum fixed cost to produce 𝐸𝐵𝐼𝑇 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = Combined Leverage =
max output. 𝐸𝐵𝑇 𝐸𝐵𝑡
OL =
(𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛)
❑ If co have pref shares : ❑ Comparative formula
(𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝐸𝐵𝐼𝑇 ) % change in EPS
❑ Comparative formula
𝐸𝐵𝐼𝑇 Combined Leverage =
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = % change in Sales
(% change in EBIT) 𝑃𝐷
Operating Leverage = 𝐸𝐵𝑇 − [ ] ❑ If CL is high co is said to be using either
(% change in sales) 1−𝑇
❑ Comparative formula more FIXED COST or debt or both
% Change in EBIT = OL x % Change in SALES % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
❑ High operating leverage shows higher burden Financial Leverage =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
of fixed cost and low EBIT. Directly proportion % Change in EPS = FL x % Change in EBIT
to business risk ❑ A higher financial leverage is better than
❑ If sales increase OL decrease & v.v. higher operating leverage

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.14
 WORKING CAPITAL LEVERAGE
SL. NO OPERATING LEVERAGE FINANCIAL LEVERAGE
Use to locate the investment in Working capital.
CA
associated with investment associated with financing Working Cap Leverage =
1 (TA+ % Change in CA )
activities activities Comparative formula
% change in ROI
Working Cap Leverage =
consists of fixed operating consists of Fixed Financial Exp % CHANGE IN WC
2
expenses
RISK AND LEVERAGE
ability to use fixed operating ability to use fixed financial
3 Risk is Divided into 2 Types :
cost. cost.
Business Risk Financial Risk
OL = Contribution/ EBIT FL = EBIT/EBT
4 refers to the risk associated with -refers to the additional risk
the firm’s operations. It is placed on firm’s shareholders as a
% change in EBIT % change in EPS represented by the variability result debt use in financing. More
5 OL = FL =
% change in SALES % change in SALES earnings before interest and tax debt would have higher financial
Trading on equity is not Trading on equity is possible (EBIT). The operating leverage risk
6 concept can be used to evaluate
possible by using operating while using FL
leverage business risk

7
Operating leverage depends Financial leverage depends EBIT - EPS ANALYSIS
upon fixed cost and variable upon the operating profits &
• Indicates to management the projected EPS for different
cost. fixed financial costs. financial plans.
• EBIT is the total earning of the co. Before paying the capital
Tax rate and interest rate will Financial leverage will change holders due
8
not affect the operating due to tax rate and interest • EPS is the total earning available to individual share holder
leverage. rate. per share

CA CS Harish A Mathariya 98220 93220 Yes Academy 8888 545 545 15.15