Capital Structure

 It Refers to the relative mix of debt and equity securities.

 It is concerned with the permanent financing of the firm.
 Two fundamental questions related to capital structure
(a) Does capital structure matter – Can the total market value of a
firm’s securities be increased or decreased by changing the
mix of debt and equity financing?
(b) If capital structure does matter, what factors determine the
optimal mix of debt and equity that will maximize the firm’s
market value and thus minimize its cost of capital?
 Factors Affecting Capital structure
 Cost Principle- The ideal capital structure is the
one which has the minimum cost and
maximise earning per share.
 Risk Principle-
1. Business risk-It is unavoidable risk because of
the enviornment in which the firm has to
operate.
2. Financial risk-It is the risk associated with the
availability of earnings per share caused by the
use of financial leverage.
 Factors Affecting Capital structure
Cont……
 Control principle-The issue of new equity will
dilute existing control pattern and also involve
higher cost while the issue of debt cause no
dilution in control but causes a high degree of
financial risk. This is mainly Felt in closely held
companies.
 Flexibility Principle- The management must
chooses such a combination of sources of
financing which it finds easier to adjust
according to changes in need of funds in future.
 Factors Affecting Capital structure
Cont…..

Other factors such as nature of industry, timing of

issue, State of economy and capital market,
competition in the industry.
The industries facing severe competition resort to
more equity than debt. The finance manager has
to have a compromise between these principles
by assigning weights to these principles in terms
of various characteristics of the company.
 Significance of capital structure
 It effects debt equity mix
 It effects shareholders return and risk

Since the cost of the debt is less, the company

prefers to borrow rather than to raise from
equity. So long as the return on investment is
more than the cost of borrowing extra borrowing
increases the earning per share. However
beyond the limit, it increases the risk and the
share prices may fall but by how much is difficult
to determine
 Significance of capital structure
Cont….
The appropriate debt equity mix can be determined within
the company taking into consideration both the types of
leverages :
Leverage = % change in the dependent variable/%
change in the independent variable.

Degree of Operating leverage=% change in EBIT/%

change in the Sales revenue

As long as the degree of operating leverage is more

than one , there is operating leverage (OL).
 Significance of capital structure
Cont….
Operating leverage exists because of the presence
of fixed cost in the cost structure of the firm.
The OL therefore is the ability to magnify the
effect of change in sales over the level of EBIT.
Higher the level of fixed cost in relation to
variable cost ,greater would be the DOL. The
DOL at any particular sales volume, also be
calculated as a ratio of contribution to the EBIT.
Operating Leverage= Contribution/EBIT
 Operating Leverage - Conclusion
 The OL is the % change in EBIT as a result of 1% change in
sales. It arises as a result of fixed cost in the cost structure.
If there is no fixed cost there will be no OL and the %
change in EBIT will be the same as % change in sales.
 A positive DOL means that the firm is operating at a level
higher than the break-even level and both the EBIT and
sales will vary in the same direction.
 A negative DOL means that the firm is operating at a level
lower than the break-even level and EBIT will be negative.

Hence the firm should always try to avoid operating under

very high DOL.
 Financial Leverage
 The Financial leverage measures the relationship
between the EBIT and EPS and it reflects the effect of
change in EBIT on the level of EPS
Financial Leverage = % Change in EPS
% Change in EBIT
= Increase in EPS/EPS
Increase in EBIT/EBIT
 If the firm is operating at a particular level then:
DFL = EBIT
EBIT - Interest
 Financial Leverage – Contd..

 If ROI is equal to cost of Debt: It is neither sensible nor

advisable to borrow the funds in this situation.
 If ROI is less than the cost of Debt: In this case the firm
will incur losses if it employs borrowed funds. This
situation is known as Unfavourable Financial Leverage.
 If ROI is more than the cost of Debt: Under this situation
the benefits will occur to the shareholders as the situation
is called as Favourable FL or Trading on Equity.
 Financial Leverage – Conclusion
 FL is a % change in EPS as a result of 1% change in
EBIT. If there is no fixed financial liability there will be
no FL
 A positive FL means that the firm is operating at a level
of EBIT which is higher than the financial break-even
level and both the EBIT and EPS will vary in the same
direction as EBIT changes.
 A negative FL means that the firm is operating at a level
lower than the financial break even level and the EPS
will be negative.
 Combined Leverage
 The OL explains the business risk complexion of the firm
whereas the financial leverage deals with the financial
risk of the firm.
 A firm having both OL and FL will have wide fluctuation
in the EPS for even a small change in the sales level.
The effect of change in the sales level on EPS is known
as the Combined Leverage.

CL = OL x FL
= % change in EBIT % change in EPS
x
% change in sales % change in EBIT
Combined Leverage - Conclusion
 CL is the % change in EPS resulting from 1% change in
Sales
 A positive CL means that the leverage is being computed
for a sales level higher than the break even level and
both EPS and Sales vary in the same direction.
 A negative CL means the leverage is being calculated for
a sales level lower than the financial break-even level
and EPS will be negative.
 EBIT – EPS Analysis

The analysis of the effect of different patterns of financing

on the level of returns of the shareholders, under different
assumptions of EBIT is known as EBIT-EPS Analysis. The
interaction between the varying level of EBIT and the
financing patterns can effect the EPS in more than one ways:
 Constant EBIT financing patterns
 Varying EBIT with different patterns.
 ILLUSTRATION- EBIT EPS Analysis
Care Ltd. which is expecting the EBIT of Rsm1,50,000 is
considering the finalisation of the capital structure. The
company has the option to raise required funds of
Rs.5,00,000:
By issuing equity share capital at par.
 50% funds by equity share capital and 50% funds by 12%
preference shares.
 50% funds by equity share capital, 25% by 12% preference
share capital and 25% by the issue of 10%Debentures.
 25% funds by equity share capital , 25% by 12% preference
share capital and 50% by the issue of 10% Debentures.
 EBIT – EPS Analysis (Contd..)
Option 1 Option 2 Option 3 Option 4
Equity Share Capital Rs. 5,00,000 Rs.2,50,000 Rs. 2,50,000 Rs. 1,25,000
Preference Share Cap - 2,50,000 1,25,000 1,25,000
10% Debentures - - 1,25,000 2,50,000
Total Funds 5,00,000 5,00,000 5,00,000 5,00,000
EBIT 1,50,000 1,50,000 1,50,000 1,50,000
-Interest - - 12,500 25,000
Profit before Tax 1,50,000 1,50,000 1,37,500 1,25,000
- Tax @ 50% 75,000 75,000 68,750 62,500
Profit after Tax 75,000 75,000 68,750 62,500
- Preference Dividend - 30,000 15,000 15,000
Profit for Equity shares 75,000 45,000 53,750 47,500
No. of Equity shares 5000 2500 2500 1250
(of Rs.100 each)
EPS (Rs.) 15 18 215 38
 Choice of capital structure
 Exclusive use of debt
 Exclusive use of Equity capital
 Exclusive use of preference capital
 Use of combination of debt and equity in
different proportion
 Use of combination of debt, equity and
preference Capital in different proportion
 Use of combination of debt and preference
capital in different proportion
 FINANCIAL BREAK-EVEN LEVEL
When the EBIT level of a company is just sufficient to
cover the fixed financial charges then such level of EBIT
is known as financial break-even level.
 If the company has employed debt as the only means
of funding its operations, the financial break-even EBIT
level is:
Financial break-even EBIT = Interest Charge
 If the company has employed debt and preference
capital as the means of funding, the financial break-even
EBIT level is:
Financial break-even EBIT = Interest Charge+
Preference Dividend/ (1-t)
 INDIFFERENCE POINT/LEVEL
The level of EBIT at which the EPS remains
same irrespective of the debt-equity mix is
known as the indifference level of EBIT. It is a
point at which the after cost of debt is just equal
to the ROI.
The use of financial break-even level and returns
from alternative capital structure is called the
indifferent point analysis, which involves using
the EBIT as a dependent variable and the EPS
from two alternative financial plans as
independent variables.
INDIFFERENCE POINT/LEVEL Cont…

 All equity financing versus Debt equity mix

EBIT(1-t)/N1=(EBIT-Int.) (1-t)/N2
 Debt Equity mix versus Debt Equity mix
(EBIT-Int1.) (1-t)/N1=(EBIT-Int2.) (1-t)/N
 All equity plan versus Equity preference plan
EBIT (1-t)/N1=EBIT(1-t)-PD/N2
 All equity plan versus Equity- preference-Debt
plan
EBIT (1-t)/N1=(EBIT-Int.)(1-t)-PD/N2
 INDIFFERENCE POINT/LEVEL
Limitations
 If neither of the two mutually exclusive
alternative financial plans involves the
issue of new equity shares, then no EBIT
indifference point exist.
 Sometimes a given set of alternative
financial plans may give negative EBIT at
indifference level.
 Illustration- Negative EBIT at
indifference level
A firm having 1,00,000 equity shares already
issued, requires additional funds of
Rs.10,00,000for which the following two options
are available
 To issue 20,000 equity shares of Rs.25 each and
to raise to Rs.5,00,000 by the issue of 9% bonds
or
 To issue 30,000 equity shares of Rs.25 each and
to raise to Rs.2,50,000 by the issue of2500 12%
preference shares of Rs.100 each.
Assume tax rate to be 50%.
 Illustration- Negative EBIT at
indifference level (Solution)

(EBIT-45,000) (1-.5)/1,20,000=EBIT
(1-.5) -30,000/1,30,000
EBIT=Rs.1,35,000
So, the indifference point occurs at a
negative value of EBIT, which is
imaginary.
 Capital Structure theories
 Is there an optimum capital stucture?
 Can the value of the firm be maximised by
effecting the financing mix or by effecting the
cost of capital?
 If the leverage effects the cost of capital and
value of the firm, then a firm should try to
achieve an optimum capital structure and
minimising the cost of capital. Is there an
optimum capital structure?
Capital Structure theories Cont….

 Net income Approach

 Net Operating Income Approach
 Traditional Approach
 Modigiliani Approach
Capital Structure theories – Common
Assumptions
 There are only two sources of funds i.e debt and equity
 Total assets of the firm are given and there would be no
change in investment decision
 No retained earning.
 Operating profits of the firm are given and are not
expected to grow.
 The business risk complextion of the firm are given and
onstant and is not effected by the financing mix.
 No corporate or personal tax.
 The investors have the same subjective probability
diistribution of expected operating profits of the firm.
 Net Income Approach
The theory states that there is a relationship
between the capital structure and the value of
the firm and therefore the firm can effect its
value by increasing or decreasing the debt
proportion in the overall financing mix.
Assumptions:
 The total capital requirement of the firm are
given and constant.
 Kd<Ke
 Both kd and ke remain constant and increase in
the financial leverage does not effect the risk
perceptio of the investors.
 Net Income Approach

Cost of
Capital (%) Ke
Ko

Kd

o Leverage (degree)
 Net Income Approach
 As Kd is less than Ke , the increasing use
of cheaper debt and simultaneous
decrease in equity proportion in overall
capital structure will magnify the returns
available to the shareholders. This will
increase the total value of equity and thus
increase the value of the firm.
Illustration-Net Income Approach
The expected EBIT of the firm is Rs.2,00,000. It has issued
share capital with ke@105 and 6% debt of Rs.5,00,000.
find out the value of the firm and WACC.
EBIT 2,00,000
Less interest 30,000
Net profit 1,70,000
Ke 10%
Value of equity 1,70,000/.10=17,00,000
Value of debt 5,00,000
Total value of the firm 22,00,000
WACC EBIT/V=2,00,000/22.00.000=9%
 TRADITIONAL APPROACH
The traditional approach has emerged as a
compromise between the extreme position taken
by NI approach and NOI approach. According to
this view a judicious use of debt and equity
capital can increase the value of the firm by
reducing the weighted average cost of capital up
to certain level of debt and it starts increasing
thereafter. This is because the increase in the
cost of equity (shareholder starts higher risk
premium in the form of higher cost of equity) is
more than offset by the lower cost of debt.
 TRADITIONAL APPROACH

Ke

Cost of Ko
Capital (%) Kd

O P Leverage (degree)
Range of Optimal
Capital Structure
(Part B)
 TRADITIONAL APPROACH

Ke
Ko
Cost of
Capital (%) Kd

O Leverage (degree)
Optimal Capital
Structure
(Part A)
 NET OPERATING INCOME
APPROACH
This is opposite to NI appoach. According to this approach
the market value of the firm depends upon EBIT and
WACC. The financing mix is irrelevant and does not
effect the value of the firm. The approach makes the
following assumptions:
 The firm sees the firm as a whole and thus capitalise the
total earnings of the firm
 The ko and Kd of the firm remains constant.
 The use of more and more of the debt in the capital
structure increases the risk of the shareholders and thus
results in the increase cost of equity to such an extent
as to completely offset the benefits of employing
cheaper debt.
 No tax.
 NET OPERATING INCOME
APPROACH
Spective In this approach, for a given value
of EBIT , the value of the firm remains
same irrespective of the capital
composition and instead depends upon
Ko.
V=EBIT/Ko and E=V-D
Cost of equity=EBIT-Interest/V-D
 NET OPERATING INCOME APPROACH

Ke

Cost of
Capital (%) Ko

Kd

o Leverage (degree)
 MODIGILIANI and MILLER
APPROACH-Assumptions
 The capital markets are perfect and
complete information is available to all the
investors without any cost. The investors
can borrow and lend the funds at the
same cost and can move from one
security to another without incurring any
transaction cost.
 The securities are infinitly divisible.
 MODIGILIANI and MILLER
APPROACH-Assumptions cont..
 Investors are rational and well informed
about the risk and return of all the
securities.
 All investors have same probability
distribution about risk return of all
securities.
 The personal and the corporate leverage
are the perfect substitutes.
 There is no corporate income tax.
 MODIGILIANI and MILLER
APPROACH
MM’s proposition I states that, for the firms in the
same risk class, the total market value is
independent of the debt equity mix and is given
by capitalising the expected net operating
income by the capitalisation rate appropriate for
that risk class.
Value of the levered firm= value of the unlevered
firm
Vl=Vu
Value of the firm=Net operating income/firms
opportunity cost of capital
V=Vl=Vu=NOI/Ko
 MM Model- Arbitrage process
MM model says that the two firms with
identical assets, irrespective how these
assets been financed, cannot command
different market values. if this was not
true and the two identical firms have
different market values, than the arbitrage
will take place to enable investors to
engage in the personal or home made
leverage as against the corporate leverage
to restore equilibrium in the market.
 Illustration-MM Model

There are two firms L and U. These firms

are alike except the firm L has 10% debt
of Rs.30,00,000 in its capital structure
while U has raised the capital only through
equity capital. Both the firms have EBIT of
Rs. 10,00,000 and Ke of 20%. Calculate
the value of the firm and Weighted
average cost of capital.
 Illustration-MM Model (Solution)
L U
EBIT 10,00,000 10,00,000
Less interest 3,00,000 -
Net profit 7,00,000 10,00,000
Ke .20 .20
Value of equity 35,00,000 50,00,000
Value of debt 30,00,000 -
Total value 65,00,000 50,00,000
15.38% 20%
 Illustration-MM Model (Solution)
The two firms similar in every aspect except the
capital structure, the levered firm has higher
value than unlevered firm. This will not persist
and the investor will involve himself in arbitrage
process. It refers to undertaking by the person
of two related actions simultaneously in order to
derive certain benefit. The investor of the higher
value firm will sell his investment and buy the
same proportion in the under value firm by
creating the personal leverage in the same ratio
as that of corporate leverage. This process will
be continued up till the value of the two firm are
equal.
 Illustration-MM Model (Solution)
cont..
In order to earn the process of arbitrage
process lets assume an investor holding
10% of the equity capital of the levered
firm. The value of the ownership right is
3,50,000 and therefore he is entitled to
get profit of 70,000. in order to avail more
profits, he shifts from levered firm to
unlevered firm by disposing his holding
worth Rs3,50,000 and purchase 10%
holding of Firm U for Rs.5,00,000. For this
 Illustration-MM Model (Solution)
cont..
He takes a loan worth Rs.3,00,000 i.e. 10%
of the debt of levered firm. Now he will be
having total funds of Rs. 6,50,000. Out of
this he invest Rs.5,00,000 and still have
1,50,000 with him.
Profits available from U firm=1,00,000
Less interest payable =30,000
Net Return =70,000
 Illustration-MM Model (Solution)
cont..
So the investor gets same return of Rs.
70,000 from unlevered firm but he can
earn more on the spare funds of Rs.
1,50,000. The total earnings will be more
while the risk remains the same and hence
the investor is better off. This leads to the
gradual increase in the sale of the shares
of levered firm and increase in the
demand of shares of unlevered firm,
making the value of the two firms equal.