Forms of Capital Structure:

The capital structure of a new company may consist of any of the following forms:
(a) Equity Shares only

(b) Equity and Preferences Shares

(c) Equity Shares and Debentures

(d) Equity Shares, Preferences Shares and Debentures.

Importance of Capital Structure:

The term ‘Capital structure’ refers to the relationship between the various long-term forms of
financing such as debenture, preference share capital and equity share capital. Financing the
firm’s assets is a very crucial problem in every business and as a general rule there should be a
proper mix of debt and equity capital in financing the firm’s assets.

The use of long-term fixed interest bearing debt and preference share capital along with equity
shares is called financial leverage or trading on equity. The long-term fixed interest bearing debt
is employed by a firm to earn more from the use of these sources than their cost so as to increase
the return on owner’s equity.

It is true that capital structure cannot affect the total earnings of a firm but it can affect the share
of earnings available for equity shareholders. Say, for example, a company has an Equity Capital
of 1000 shares of Rs. 100 each fully paid and earns an average profit of Rs. 30,000. Now the
company wants to make an expansion and needs another Rs. 1,00,000.

The options with the company are-either to issue new shares or raise loans @ 10% p.a.
Assuming that the company would earn the same rate of profits. It is advisable to raise loans as
by doing so earnings per share will magnify. The company shall pay only Rs. 10,000 as interest
and profit expected shall be Rs. 60,000 (before payment of interest).

After the payment of interest the profits left for equity shareholders shall be Rs. 50,000 (ignoring
tax). It is 50% return on the equity capital against 30% return otherwise. However, leverage can
operate adversely also if the rate the interest on long-terms loans is more than the expected rate
of earnings of the firm.
The impact of leverage on earnings per share (EPS) can be understood with the help of following
illustration.

Illustration 1:
ABC Company has currently an all equity capital structure consisting of 15,000 equity shares of
Rs. 100 each.

The management is planning to raise another Rs. 25 lakhs to finance a major programme
of expansion and is considering three alternative methods of financing:
(i) To issue 25,000 equity shares of Rs. 100 each.

(ii) To issue 25,000, 8% debentures of Rs. 100 each.

(iii) To issue 25,000, 8% Preference Shares of Rs. 100 each.

The company’s expected earnings before interest and taxes will be Rs. 8 lakhs. Assuming a
corporate tax rate of 50 per cent, determine the earnings per share (EPS) in each alternative and
comment which alternative is best and why?
Comments:
As the earnings per share are highest in alternative II, i.e., debt financing, the company should
issue 25,000 8% debentures of Rs. 100 each. It will double the earnings of the equity
shareholders without loss of any control over the company.
Illustration 2:
A Ltd. Company has equity share capital of Rs. 5,00,000 divided into shares of Rs. 100 each. It
fishes to raise further Rs. 3,00,000 for expansion cum modernisation plans.

The company plans the following financing schemes:

(a) All common stock

(b) Rs. one lakh in common stock and Rs. two lakhs in debt @ 10% p.a.

(c) All debts at 10% p.a.

(d) Rs. one lakh in common stock and Rs. two lakh in preference capital with the rate of dividend
at 8%.

The company’s expected earnings before interest and tax (EBIT) are Rs. 1, 50,000. The
corporate rate of tax is 50%. Determine the Earnings per share (EPS) in each plan and comment
on the implications of financial leverage.

Solution:

Comments:
In the four plans of fresh financing, Plan III is the most leveraged of all. In this case, additional
financing is done by raising loans @ 10% interest. Plan II has fresh capital stock of Rs. One lakh
while Rs. two lakhs are raised from loans. Plan IV does not have fresh loans but preference
capital has been raised for Rs. two lakhs.
The earnings per share are highest in Plan III, i.e. Rs. 12. This plan depends upon fixed cost
funds and thus has benefited the common stock-holders by increasing their share in profits. Plan
II is the next best scheme where EPS is Rs. 10.83. In this case too Rs. 2 lakhs are raised through
fixed cost funds. Even Plan IV, where preference capital of Rs. 2 lakhs is issued, is better than
plan I where common stock of Rs. 3 lakh is raised.

The analysis of this information shows that financial leverage has helped in improving earnings
per share for equity shareholders. It helps to conclude that higher the ratio of debt to equity the
greater the return for equity stockholders.

Impact of Leverage on Loss:

If a firm suffers losses then the highly leveraged scheme will magnify the losses per share.

This impact is discussed in illustration below:

Illustration 3:
Taking the figure in illustration 3, a concern suffers a loss of Rs. 70,000.

Discuss the impact of leverage under all the four plans:

Solution:

Comments:
The loss per share is highest in Plan III because it has the higher debt-equity ratio while it is
lowest in Plan I because all additional funds are raised through equity capital. The leverage will
have adverse impact on earning if the firm suffers losses because fixed cost securities will
magnify the losses.

Illustration 4:
AB Ltd. needs Rs. 10,00,000 for expansion. The expansion is expected to yield an annual EBIT
of Rs. 1,60,000. In choosing a financial plan, AB Ltd. has an objective of maximising earnings
per share. It is considering the possibility of issuing equity shares and raising debt of Rs.
1,00,000 or Rs. 4,00,000 or Rs. 6,00,000.
The current market price per share is Rs. 25 and is expected to drop to Rs. 20 if the funds are
borrowed in excess of Rs. 5,00,000.

Funds can be borrowed at the rates indicated below:

(a) Upto Rs. 1,00,000 at 8%.

(b) Over Rs. 1,00,000 upto Rs. 5,00,000 at 12%.

(c) Over Rs. 5,00,000 at 18%.

Assume a tax rate of 50 percent. Determine the EPS for the three financing alternatives and
suggest the scheme which would meet the objective of the management.

Solution:

Suggestions:
As the company has an objective of maximising earnings per share, alternative II, i.e. raising a
debt of Rs. 4,00,000 and equity of Rs. 6,00,000 would meet the objective. The EPS is the highest
under alternative II.

Planning the Capital Structure:

Estimation of capital requirements for current and future needs is important for a firm. Equally
important is the determining of capital mix. Equity and debt are the two principle sources of
finance of a business. But, what should be the proportion between debt and equity in the capital
structure of a firm?
How much financial leverage should a firm employ? This is a very difficult question. To answer
this question, the relationship between the financial leverage and the value of the firm or cost of
capital has to be studied. Capital structure planning, which aims at the maximisation of profits
and the wealth of the shareholders, ensures the maximum value of a firm or the minimum cost of
capital.

It is very important for the financial manager to determine the proper mix of debt and equity for
his firm. In principle, every firm aims at achieving the optimal capital structure but in practice it
is very difficult to design the optimal capital structure. The management of a firm should try to
reach as near as possible of the optimum point of debt and equity mix