Chapter 20 –

Designing Capital Structure

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 Learning Objectives
• Review the key factors having a bearing on the choice of an appropriate capital
structure
• Illustrate EBIT-EPS analysis and coverage ratio as an approach to design capital
structure
• Explain cash flow analysis as an approach to set debt policy for a firm
• Examine the other factors having a bearing on planning the sources of funds
• Analyse financing alternatives from the viewpoint of tax planning
• Outline capital structure practices by corporates in India

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 Introduction
• The capital structure is said to be optimum when the marginal real cost (explicit
as well as implicit) of each available source of financing is identical.
• With an optimum debt and equity mix, the cost of capital is minimum and the
market price per share (or total value of the firm) is maximum.
• The use of debt in capital structure or financial leverage has both benefits as well
as costs.
• While the principal attraction of debt is the tax benefit, its cost is financial
distress and reduced commercial profitability.
• Financial distress includes a broad spectrum of problems ranging from minor
liquidity shortages to bankruptcy.
• The terms designing capital structure, capital structure decision, factors
determining capital structure and capital structure planning are used
interchangeably.
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 Key Factors
• The key factors governing the capital structure decisions are:
 profitability aspect,
 liquidity aspect,
 control,
 leverage ratios in industry,
 nature of industry,
 consultation with investment banks/lenders,
 commercial strategy,
 timing,
 company characteristics and
 tax planning.

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 Profitability Aspect: Earnings Before Interest and
Tax (EBIT) – Earnings Per Share (EPS) Analysis
• The EBIT-EPS analysis should be considered logically as the first step in the
direction of designing a firm’s capital structure.
• EBIT-EPS analysis/approach is an approach for selecting capital structure that
maximises earnings per share (EPS) over the expected range of earnings before
interest and taxes.

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 Coverage Ratio
• Apart from the EBIT-EPS/EBIT-MPS analysis, the ability of a firm to use debt, from
the profitability point of view, can also be judged in terms of a coverage ratio,
namely,

Or

• Coverage ratio measures the size of interest payments relative to the EBIT and
the adequacy of EBIT to meet payment obligations.

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 Liquidity Aspect: Cash Flow Analysis
• Liquidity position of a firm is analysed by cash flow analysis.
• Cash flow analysis evaluates the risk of financial distress.
• In assessing the liquidity position of a firm in terms of its cash flow analysis,
various measures can be employed.
• One such measure is the ratio of fixed charges to net cash inflows.
• This ratio measures the coverage of fixed financial charges (interest plus
repayment of principal, if any) to net cash inflows.
• The greater the coverage ratio, the greater is the amount of debt (and other
sources of funds carrying a fixed rate of interest/dividend) that a firm can use.

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• Another measure is to prepare a cash budget to determine whether the expected
cash flows are sufficient to cover the fixed obligations.
• The purpose of preparing the cash budget is to find out possible deviations in
actual cash flows from those that are expected.
• Since the probability of various cash flow patterns is known, the firm can work
out the amount of fixed charges as well as the debt that the firm can employ and
still remain within an insolvency limit tolerable to the management.
• Debt capacity relates to how much debt can be comfortably serviced.

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 Cashflow Analysis in Recession
• To prepare forecasts of cash flows under recession conditions, cash flows are
divided into three categories:
 operating;
 non-operating; and
 financial flows.
• Operating Cash Flows cover sales revenues and cash operating expenses.
• Non-operating Cash Flows include capital outlays and changes in working capital.
• Financial Flows cover lease payments, interest on debt, repayment of principal,
taxes and dividends

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 Other Factors
Control
• Another consideration in planning the types of funds to use is the attitude of the
management towards control.
Leverage Ratios For Other Firms in the Industry
• Yet another approach to the capital structure decisions is to make a comparison with
the debt-equity ratios of companies belonging to the same industry, having a similar
business risk.
Nature of Industry
• The nature of industry is one of the most important elements in determining the
degree of financial leverage a firm can carry safely without any risk of bankruptcy.
Consultation with Investment Bankers and Lenders
• Another useful approach in deciding the proportion of various securities in a firm’s
structure is to seek the opinion of investment analysts, institutional investors,
investment bankers and lenders.
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Maintaining Manoeuverability for Commercial Strategy
• Manoeuvrability implies the ability to adjust source of funds in response to
change in the need for funds.
• Flexibility as to financing is important when future external financing will be
necessary.
Timing of Issue
Closely related to flexibility in deciding the types of funds to be used, is the
question of timing.
Characteristics of the Company
• The characteristics of a company in terms of size and credit standing, among
others, also play a vital role in determining the share of senior securities and
equity in its capital structure.

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 Tax Planning
• Tax planning is likely to have a significant bearing on capital structure decisions.
• Under the Income Tax Act, 1961, while interest on borrowed funds is allowed as a
deduction under Section 36(1)(iii), dividend on shares is not deductible from the
operating profits of a company.
• With effect from April 1, 2003, distributed profits are subject to an extra 10 per cent
tax under Sections 115O.
• Secondly, cost of raising finance through borrowings is deductible in the year of
incurrence. If, however, it is incurred during pre-commencement of business period,
it has to be capitalised.
• The cost of issue of shares is allowed as a deduction in 10 years under Section 35 D.
• As a result, corporate taxation is an important determinant of the choice between
different sources of financing.

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