AJAY KUMAR GARG INSTITUTE OF MANAGEMENT

Capital Structure
Unit - III
By

Dr. Simmi Khurana

 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.
• .
 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 and is considering three alternative methods of
financing : 
• To issue 23.000 equity shares of Rs. 100 each.
• To issue 25.000, 89, debentures of Rs. 100 cach.
• To issue 25,000, 8%Preference Shares of Rs.100 each. 
• The commpany 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 
 Financial Break-Even Point

Financial break even point may be defined as that level of EBIT which is just financial
charges, ie interest and preference dividend. At this point or level of tax, the earnings per
share equals zero (EPS = 0). It is a critical point in planning the car If earning before interest
and tax is less than the financial break even point, the earnings negative and hence fixed
interest bearing debt or preference share capital should be reduced of the firm. However, in
case the level of EBIT exceeds the financial break even point me funds may be inducted in the

capital structure .
 Point of indifference
• The EPS, earnings per share, 'equivalency point or point of indifference' refers to that EBIT, earnings before
interest and tax, level at which EPS remains the same irrespective of different alternatives of debt–equity mix.
• At this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also ok even
level of EBIT for alternative financial plans .The point of indifference can be calculated algebraically, as
below: 
• (X-11) (1 - 1) – PD = (X-12) (1-1) - PD 
• S1 S2
• X= Equivalency Point or Point of Indifference or Break Even EBIT Level
• į = Interest under alternative financial plan 1.
• I2 = Interest under alternative financial plan 2
• . T = Tax Rate
• PD = Preference Dividend
• S1 = Number of equity shares or amount of equity share capital under alternative 1.  
• S2 = Number of equity shares or amount of equity share capital under alternative
• A project under consideration by your company requires a capital investment of Rs. 60 Lakhs.
Interest on term loan is 10% p.a. and tax rate is 50% Calculate the point of indifference for the
project, of the debt-equity ratio insisted by the financing agencies is 2:1
• As the debt equity ratio insisted by the financing agencies is 2:1, the company has two
alternative financial plans : 
• (i) Raising the entire amount of Rs. 60 lakhs by the issue of equity shares, thereby using no
debt, 
• and (ii) Raising Rs.40 lakhs by way of debt and Rs.20 lakh by issue of equity share capital.
 Optimal Capital Structure

• The capital structure decision can influence the value of the firm through the of capital and
trading on equity or leverage. The optimum capital structure may be defined as “that capital
structure or combination of debt and equity that leads to the maximum value of the firm”
Optimal c. structure ‘maximises the value of the company and hence the wealth of its owners
and minimises the comp cost of capital.Thus, every firm should aim at achieve the optimal

capital structure and then to maintain it.  

 THEORIES OF CAPITAL STRUCTURE 

• Different kinds of theories have been propounded by different authors to explain

the relationship between capital structure, cost of capital and value of the firm. The
main contributors to the theories Ezra, Solomon, Modigliani and Miller 
• The important theories are discussed below : 
• 1. Net Income Approach 
• 2. Net Operating Income Approach. * 
• 3. The Traditional Approach
 Net Income Approach

According to this approach, a firm can minimise the weighted average of capital
and increase the value of the firm as well as market price of equity shares by using
debt financing to the maximum possible extent.
The theory propounds that a company can increase its value and decrease the
overall cost of capital by increasing the proportion of debt in its capital structure.

This approach is based upon the following assumptions : 

(i) The cost of debt is less than the cost of equity.
(ii) There are no taxes.
(iii) The risk perception of investors is not changed by the use of debt. 
- 
 Net Income Approach

X Ltd. is expecting an annual EBIT of Rs. 1 lakh. The company has Rs. 4 lakhs in
10% debentures. The cost of equity capital or capitalisation rate is 12.5%. You are
required to calculate the total value of the firm according to the Net Income
Approach
 Net Operating Income Approach

• This theory as suggested by Durand is another extreme of the effect of leverage on the
value of the firm . It is diametrically opposite to the net income approach.
• According to this approach, change in the capital structure of a company does not
affect the market value of the firm and the overall cost of capital remains constant
irrespective of the method of financing.
• It implies that the overall cost of capital remains the same whether the debi-equity mix
is 50: 50 or 20:80 or 0:100. Thus, there is nothing as an optimal capital structure and
every capital structure is the optimum capital structure. This theory presumes that: 
• (i) the market capitalises the value of the firm as a whole;
• (ii) the business risk remains constant at every level of debt equity mix;
• (111) there are no corporate tax
Value of the firm on the basis of Net
operating Income Approach
(a) A company expects a net operating income of Rs. 1,00,000. It has Rs.5,00,000, 6%
Debentures. The overall capitalisation rate is 10%.Calculate the value of the firm and the
equity capitalisation rate (cost of equity) according to the Net Operating Income
Approach. 
(b) If the debenture debt is increased to Rs 7,50,000. what will be the effect on the value
of the firm and the equity capitalisation rate?
Equity Capitalisation rate = EBIT-I/V-D
= 100,000-45000 * 100 =22%
10,00,000-7,50,000
 The Traditional Approach

• The traditional approach, also known as Intermediate compromise between the two extremes
of net income approach and net operating income to this theory, the value of the firm can be
increased initially or the cost of capital can be more debt as the debt is a cheaper source of
funds than equity.
• Thus, optimum capital structure by a proper debt-equity mix. Beyond a particular point, the
cost of equity increases because in increases the financial risk of the equity shareholders.
• The advantage of cheaper debt at this poi structure is offset by increased cost of equity. After
this there comes a stage, when the increased cannot be offset by the advantage of low-cost
debt.
• Thus, overall cost of capital, according to decreases up to a certain point, remains more or less
unchanged for moderate increase in debt the increases or rises beyond a certain point. Even
the cost of debt may increase at this stage due to financial risk
• Compute the market value of the firm ,value of shares and average cost of capital
Net operating Income 2,00,000
Total Borrowings 10,00,000
Equity Capitalisation rate
(1) If the firm uses no debt
(2) If the frim uses Rs 4,00,000 debentures
(3) If the firm uses Rs 6,00,000 debenture
Assume that Rs 4,00,000 debenture can be rasied at 5% rate of interest whereas Rs 6,00,000
debenture can be rasied at 6% rate of return
 LEVERAGE ANALYSIS- MEANING

• Meaning of Leverage:

i. Leverage means involvement of fixed cost.

ii. In other words it can be said firm’s ability to utilize fixed cost.

• Types of Fixed Cost:

i. Operating Fixed Cost: Depreciation, Salary, Insurance etc. (does not include interest
expenses)

ii. Financial Fixed Cost: Interest on borrowed fund i.e. Interest on Debentures, bank Loan
etc
 Types of Leverage Analysis

• Operating Leverage: Calculated to analysis the impact of

fixed operating cost on Sales and EBIT.

• Financial Leverage: Calculated to analysis the impact of

fixed financial cost on EBIT and EBT.

• Combined Leverage: Calculated to analysis the impact of

both fixed costs i.e. operating and financial cost.
 Income statement Format
• Sales
-Variable cost
Contribution
-Fixed Operating cost
EBIT
-TAX
EBT
Formula:

• Operating Leverage • Financial Leverage

= Contribution = EBIT
EBIT EBT
THANK YOU