KMBN204

UNIT-3
Capital Structure
According to Gerestenberg, ‘capital structure of a company refers to the composition or make up
of its capitalization and it includes all long term capital resources viz., loans, reserves, shares and
bonds’.
Keown et al. defined capital structure as, ‘balancing the array of funds sources in a proper
manner, i.e. in relative magnitude or in proportions’.
In the words of P. Chandra, ‘capital structure is essentially concerned with how the firm decides
to divide its cash flows into two broad components, a fixed component that is earmarked to meet
the obligations toward debt capital and a residual component that belongs to equity
shareholders’.

Concept of Capital Structure

The relative proportion of various sources of funds used in a business is termed as financial
structure. Capital structure is a part of the financial structure and refers to the proportion of the
various long-term sources of financing. It is concerned with making the array of the sources of
the funds in a proper manner, which is in relative magnitude and proportion.
The capital structure of a company is made up of debt and equity securities that comprise a
firm’s financing of its assets. It is the permanent financing of a firm represented by long-term
debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short-
term borrowings. It denotes some degree of permanency as it excludes short-term sources of
financing.
Again, each component of capital structure has a different cost to the firm. In case of companies,
it is financed from various sources. In proprietary concerns, usually, the capital employed, is
wholly contributed by its owners. In this context, capital refers to the total of funds supplied by
both—owners and long-term creditors.

Importance of Capital Structure

(i) Value Maximization
Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed
capital structure the aggregate value of the claims and ownership interests of the shareholders are
maximized.
(ii) Cost Minimization
Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a
proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.
(iii) Increase in Share Price
Capital structure maximizes the company’s market price of share by increasing earnings per
share of the ordinary shareholders. It also increases dividend receipt of the shareholders.
(iv) Investment Opportunity
Capital structure increases the ability of the company to find new wealth- creating investment
opportunities. With proper capital gearing it also increases the confidence of suppliers of debt.
(v) Growth of the Country

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Capital structure increases the country’s rate of investment and growth by increasing the firm’s
opportunity to engage in future wealth-creating investments.
Factors Affecting Capital Structure
1. Cash Flow Position
The decision related to composition of capital structure also depends upon the ability of business
to generate enough cash flow.
The company is under legal obligation to pay a fixed rate of interest to debenture holders,
dividend to preference shares and principal and interest amount for loan. Sometimes company
makes sufficient profit but it is not able to generate cash inflow for making payments.
The expected cash flow must match with the obligation of making payments because if company
fails to make fixed payment it may face insolvency. Before including the debt in capital structure
company must analyse properly the liquidity of its working capital.
A company employs more of debt securities in its capital structure if company is sure of
generating enough cash inflow whereas if there is shortage of cash then it must employ more of
equity in its capital structure as there is no liability of company to pay its equity shareholders.
2. Interest Coverage Ratio (ICR)
It refers to number of time companies earnings before interest and taxes (EBIT) cover the
interest payment obligation.
ICR= EBIT/ Interest
High ICR means companies can have more of borrowed fund securities whereas lower ICR
means less borrowed fund securities.
3. Debt Service Coverage Ratio (DSCR)
It is one step ahead ICR, i.e., ICR covers the obligation to pay back interest on debt but DSCR
takes care of return of interest as well as principal repayment.
If DSCR is high then company can have more debt in capital structure as high DSCR indicates
ability of company to repay its debt but if DSCR is less then company must avoid debt and
depend upon equity capital only.
4. Return on Investment
Return on investment is another crucial factor which helps in deciding the capital structure. If
return on investment is more than rate of interest then company must prefer debt in its capital
structure whereas if return on investment is less than rate of interest to be paid on debt, then
company should avoid debt and rely on equity capital. This point is explained earlier also in
financial gearing by giving examples.
5. Cost of Debt
If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as
compared to equity.
6. Tax Rate
High tax rate makes debt cheaper as interest paid to debt security holders is subtracted from
income before calculating tax whereas companies have to pay tax on dividend paid to
shareholders. So high end tax rate means prefer debt whereas at low tax rate we can prefer equity
in capital structure.
7. Cost of Equity
Another factor which helps in deciding capital structure is cost of equity. Owners or equity
shareholders expect a return on their investment i.e., earning per share. As far as debt is

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increasing earnings per share (EPS), then we can include it in capital structure but when EPS
starts decreasing with inclusion of debt then we must depend upon equity share capital only.
8. Floatation Costs
Floatation cost is the cost involved in the issue of shares or debentures. These costs include the
cost of advertisement, underwriting statutory fees etc. It is a major consideration for small
companies but even large companies cannot ignore this factor because along with cost there are
many legal formalities to be completed before entering into capital market. Issue of shares,
debentures requires more formalities as well as more floatation cost. Whereas there is less cost
involved in raising capital by loans or advances.
9. Risk Consideration
Financial risk refers to a position when a company is unable to meet its fixed financial charges
such as interest, preference dividend, payment to creditors etc. Apart from financial risk business
has some operating risk also. It depends upon operating cost; higher operating cost means higher
business risk. The total risk depends upon both financial as well as business risk.
If firm’s business risk is low then it can raise more capital by issue of debt securities whereas at
the time of high business risk it should depend upon equity.
10. Flexibility
Excess of debt may restrict the firm’s capacity to borrow further. To maintain flexibility it must
maintain some borrowing power to take care of unforeseen circumstances.
11. Control
The equity shareholders are considered as the owners of the company and they have complete
control over the company. They take all the important decisions for managing the company. The
debenture holders have no say in the management and preference shareholders have limited right
to vote in the annual general meeting. So the total control of the company lies in the hands of
equity shareholders.
If the owners and existing shareholders want to have complete control over the company, they
must employ more of debt securities in the capital structure because if more of equity shares are
issued then another shareholder or a group of shareholders may purchase many shares and gain
control over the company.
Equity shareholders select the directors who constitute the Board of Directors and Board has the
responsibility and power of managing the company. So if another group of shareholders gets
more shares then chance of losing control is more.
Debt suppliers do not have voting rights but if large amount of debt is given then debt-holders
may put certain terms and conditions on the company such as restriction on payment of dividend,
undertake more loans, investment in long term funds etc. So company must keep in mind type of
debt securities to be issued. If existing shareholders want complete control then they should
prefer debt, loans of small amount, etc. If they don’t mind sharing the control then they may go
for equity shares also.
12. Regulatory Framework
Issues of shares and debentures have to be done within the SEBI guidelines and for taking loans.
Companies have to follow the regulations of monetary policies. If SEBI guidelines are easy then
companies may prefer issue of securities for additional capital whereas if monetary policies are
more flexible then they may go for more of loans.
13. Stock Market Condition

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There are two main conditions of market, i.e., Boom condition. These conditions affect the
capital structure specially when company is planning to raise additional capital. Depending upon
the market condition the investors may be more careful in their dealings.
During depression period in the market business is slow and investors also hesitate to take risk so
at this time it is advisable to issue borrowed fund securities as these are less risky and ensure
fixed
repayment and regular payment of interest but if there is Boom period, business is flourishing
and investors also take risk and prefer to invest in equity shares to earn more in the form of
dividend.
14. Capital Structure of other Companies
Some companies frame their capital structure according to Industrial norms. But proper care
must be taken as blindly following Industrial norms may lead to financial risk. If firm cannot
afford high risk it should not raise more debt only because other firms are raising.

LEVERAGE

Leverage is a company’s capacity to utilise new resources or assets to make better returns or to
diminish costs. Leverage is the reason that is influential for any organisation is extremely huge.
Leverage is used to describe the firm’s ability to use fixed cost assets or funds to magnify the
return to its owners. James van Home has defined leverage, as “the employment of an asset or
funds for which the firm pays a fixed cost or fixed return.” In other words, Leverage is the
employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of
interest obligation irrespective of the level of activities or the level of operating profit.
When a firm uses fixed assets, it Results in fixed operating costs. Similarly when a firm uses
those sources of finance in its capital structure on which it is required to pay fixed cost or fixed
rate of interest, it results in fixed financial costs. Higher is the degree of leverage higher is the
risk and higher is the expected return and vice versa.
The leverage can be favourable or unfavourable as the fixed cost or return has to be paid
irrespective of the volume of sales, the amount of such cost or return has a significant effect on
the profits available for equity shareholders.
The term Leverage in general refers to a relationship between two interrelated variables. In
financial analysis it represents the influence of one financial variable over some other related
financial variable. These financial variables may be costs, output, sales revenue, earnings before
interest and tax, earnings before tax, earning per share, etc.
There are three commonly used measures of leverages in financial analysis. These are: 
(i) Operating leverage, 
(ii) Financial leverage, and 
(iii) Combined leverage. 
(i) Operating Leverage : 
Operating Leverage is defined as “the firm’s ability to use fixed operating costs to magnify
effects of changes in sales on its earnings before interest and taxes”. In other words operating
leverage is the tendency of the operating profit to vary disproportionately with sales. It is said to
exist when a firm has to pay fixed cost regardless of volume of output or sales. 
The operating leverage shows the relationship between the changes in sales and the changes in
fixed operating income. Thus, the operating leverage has an impact mainly on fixed costs and

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also on variable costs and contribution. Of course, there will be no operating leverage if there are
no fixed operating costs. 
The operating leverage can be calculated by adopting the following formula:

(ii) Financial Leverage:

The financial leverage is defined as the ability of a firm to use fixed financial charges to magnify
the effects of changes in operating profits, on the firm’s earning per share. In other words, the
financial leverage is the tendency of a residual net income to vary disproportionately with
operating profit. It indicates the change that takes place in the taxable income as a result of
change in the operating income.
Financial leverage refers to using borrowed amount for purchasing assets to build capital and
expand a business, with an expectation of earning or reaping gains, which would be more than
the cost incurred in borrowing from lenders. Here, the assets purchased act as collateral until the
loan is fully repaid along with interest.

The financial leverage can be computed by adopting the following formula: 

(iii) Combined Leverage:

The operating leverage explains the operating risk and financial leverage explains the financial
risk of the firm. However, a firm has to look into overall risk or total risk of the firm i.e.,
operating risk as well as financial risk. Hence, if we combine the operating risk and financial

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risk, the result is combined leverage. Combined leverage thus expresses the relationship between
revenue on account of sales and the taxable income.
The combined leverage can be computed by adopting following formula:

Importance of Leverage

With the understanding of leverage, a finance manager can increase earnings per share and
dividend per share to equity shareholders as well as market value of the firm. When the rate
of return on investment is more than the cost of debt capital, it gives more rate of return on
equity capital. This in turn maximises shareholders’ wealth, which is the basic objective of
financial management. The leverage can help increase both the EPS and EBT.
The importance of leverage can be judged from the following points:
1. Leverage is an important technique in deciding the optimum capital structure of a firm.
With the help of this technique, it is easy to determine the ratio of various securities
comprising the capital structure of a firm at which the average cost of capital is minimum. If
financial leverage is present in a firm, it is possible to increase EPS by increasing the EBIT
in a firm.
2. Leverage is also very helpful in taking a capital budgeting decision. If contribution in a
firm is not able to meet the fixed operating costs, then business will suffer loss. In other
words, the degree of operating leverage must be greater than 1 to make the project
operationally profitable.
3. Leverage is most important in assessing the risk involved in a firm. Operating leverage
measures the business risk of a firm. Financial leverage measures the financial risk in a
firm. The combined leverage measures the total risk involved in a firm.
In leverage analysis, it is assumed that cost of capital always remains constant. But, after a
certain limit, the cost of financing generally starts increasing.
The use of more debt capital increases the risk level in a firm which results in reduction in
the value of shares. Thus, in leverage analysis, explicit cost of debt capital is considered,
while its implicit costs are ignored. Leverage principle assumes that the required additional
debt capital should.be raised till the expected rate of return on investment is higher than cost
of debt capital. 

Indifference Point

The indifference point refers to that level of EBIT at which EPS are the same regardless of
leverage in alternative financial plans. At this level, all financial plans are equally desirable
and the management is indifferent between alternative financial plans as far as the EPS is
concerned.

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In other words, it is that level of EBIT at which it is immaterial for the financial manager as
to which capital structure or capital mix he adopts for the company. At this point, the use of
debt capital or a change in this proportion in the total capital will not affect the return to
equity shareholders or earning per share.
It is also called the debt-equity indifference point and can be determined mathematically in
the following manner:

Relevance of Calculation of Indifference Point:

The determination of indifference points helps in ascertaining the level of operating profit
(EBIT) beyond which the debt alternative is beneficial because of its favorable effect on
earnings per share.
In other words, it is profitable to raise debt for strengthening EPS, if there is likelihood that
future operating profits are going to be higher than the level of EBIT as determined. On the
other hand, it is advisable to issue equity shares for raising more funds if it is expected that
EBIT is going to be lower than that determined. 

EBIT-EPS Analysis

The EBIT-EPS analysis is carried out to assess the impact of different financial proposals on
the value (EPS) of the company. Since the basic aim of financial management is to
maximise the wealth of shareholders, the EBIT-EPS analysis is crucial in maximising the
wealth of the company.
The financial proposal having the highest EPS is considered for the execution. The different
financial proposals may be the use of, only equity, combination of equity and debt,
combination of equity and preferential capital, or any combination of equity, debt and
preferential capital. EBIT-EPS analysis shows the impact of financial leverage on the EPS
of the company under different financial proposals.

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FORMULA
SALES(REVENUE)
-VARIABLE COST
=CONTRIBUTION
-FIXED COST
=EBIT
-INTEREST
=EBT
-TAX
=EAT
-PRE. SHARE HOLDERS DIVIDEND
=EARNINGS AVALAIBLE FOR EQUITY SHARE HOLDERS

EARNINGS PER SHARE(EPS)= EARNINGS AVALAIBLE FOR EQUITY SHARE

HOLDERS/NO. OF OUTSTANDING EQUITY SHARES

The example given below explains the concept of EBIT-EPS analysis:

Example:
Tulip Limited is planning to set up an industrial plant costing Rs. 40,00,000. It is expected
the plant will yield an EBIT of Rs. 8,00,000 per annum.
Solution:
Computation of EPS under different financial proposals:

Financial Break Even Level

It is that level of EBIT at which EPS is zero and the firm is just able to meet all fixed
financial payments like interest on debt and preference dividend.
It can be found out by solving the following equation: 

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Limitations of Leverage

Leverage  as a tool of financial management, suffers from the following limitations:

(a) Implicit Cost of Debt Ignored:
The leverage analysis relies on the explicit cost of debt. It suggests that the use of additional
debt capital as long as explicit cost of debt exceeds the rate of return on capital employed.
However, the increased use of debt capital tends to make the firm financially risky that is
reflected by reduction in price of shares in the market. 
The intending investor in equity capital expects a higher rate of return as a compensation for
increase in risk. This additional risk premium is the implicit cost of debt that is completely
ignored.
(b) Increase in Cost of Debt:
With increase in use of debt, the debt equity ratio tends to increase. As a result, the
prospective providers of debt funds hesitate to provide additional debt, except at a higher
rate of interest. But a basic assumption of leverage analysis is that the cost of debt capital
remains unchanged irrespective of amount of borrowings.
(c) Debt with Captive Market: The biggest limitation of the leverage analysis is that they
look at the total amount of borrowing, not the firm’s ability to actually service its debt.
Some firms, with captive markets, may carry a significant amount of debt, but they generate
enough cash to easily handle interest payments. Such firms are labeled as being risky though
they may not be because of the captive market they enjoy. 

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