Capital Structure in Practice

Lesson 6: Module 4

Goals
Understand practical considerations in
capital structure decisions
Concept of business risk and impact of
leverage on the bottom line of an
organization.

FEATURES OF A SOUND
CAPITAL STRUCTURE
1. RETURN
2. RISK
3. FLEXIBILITY
4. CAPACITY ( DEBT CAPACITY )
5. CONTROL

3 approaches
EBIT EPS Analysis
Cash flow
Valuation

APPROACHES

1. EBIT EPS ANALYSIS

GOOD

E.B.I.T.
INTEREST

E.B.T
TAX
E.A.T.
E.P.S.

AVERAGE

BAD

EBIT EPS ANALYSIS

A

E
P
S
POINT OF
INDIFFERENCE

E1
EBIT

E2

CASH FLOW APPROACH

CASH FLOWS
FINANCIAL FLOWS

OPERATING

NON OPERATING

ABILITY TO SERVICE
THE DEBT

VALUATION APPROACH

MINIMISE COST OF CAPITAL

TRADE OFF THEORY

PICKING ORDER
THEORY
INTERNAL
EARNINGS

E.P.S.
DEBT
DEBT
( FINANCIAL
DISTRESS)
COST OF
CAPITAL

HYBRID
INSTRUMENTS
EQUITY

PRACTICAL CONSIDERATIONS
CONTROL
FLEXIBILITY
LOAN COVENANTS
MARKETABILITY
FLOATAION COSTS
CAPACITY OF RAISING FUNDS
AGENCY COSTS

BUSINESS RISK
OPERATING RISK
(Use of fixed assets in the cost structure)
FINANCIAL RISK
Use of debt in the capital structure
Together combined risk

Measurement of risk

Operating risk & Financial risk

Degree of Operating Leverage (DOL)

%change in EBIT / % change in sales
Contribution / EBIT

Degree of Financial Leverage (DFL)

% change in EPS / % change in EBIT
EBIT / EBIT-I

Case study

Garden Ltd.

Thank you