CAPITAL STRUCTURE DECISION

LEARNING OBJECTIVES

• After going through this topic, students should be able to:

 Understand the sensitivity of EPS to PBIT under different capital
structures.
 Discuss the relationship between ROI and ROE under different capital
structures.
 Broadly assess the debt capacity of a firm.
 List the factors that have a bearing on the capital structure decision.
PBIT – EPS ANALYSIS

• Basic Relationship: Let us consider the following data for Falcon

Limited.
• Existing Capital Structure : 1 million equity shares of $10 each.
• Tax rate : 50%
• Falcon Limited plans to raise additional capital of $10 million for
financing an expansion project. In this context it is evaluating two
alternative financing plans: (i) issue of equity shares (1 million equity
shares at $10 per share), and (ii) issue of debentures carrying 14 %
interest. What will be the EPS under the two alternative financing
plans for two levels of PBIT, say $4 million and $2 million?
Earnings Per Share under Alternative Financing Plans

Equity Financing Debt Financing

PBIT PBIT PBIT PBIT
2 000 000 4 000 000 2 000 000 4 000 000
Interest - - 1 400 000 1 400 000
Profit before taxes 2 000 000 4 000 000 600 000 2 600 000
Taxes 1 000 000 2 000 000 300 000 1 300 000
Profit after tax 1 000 000 2 000 000 300 000 1 300 000
No. of equity
shares 2 000 000 2 000 000 1 000 000 1000 000
Earnings per share 0,50 1,00 0,30 1,30
In general, the relationship between PBIT and EPS is as follows:
EPS = (PBIT – I)(1 – t)
n
Where I is the interest burden, t is the tax rate, and n is the number of equity
shares.
When preference dividend (Dp) is payable, the relationship becomes:
EPS = (PBIT – I) (1 – t) - Dp
n
Break-even PBIT Level

• The break-even PBIT for two alternative financing plans is the level of PBIT
for which the EPS is the same under both financing plans. This can be
obtained mathematically by solving the equation for PBIT*
(PBIT* - I1)(1 – t) = (PBIT* - I2)(1 – t)
n1 n2
Where PBIT* is the indifference point between the two alternative plans, I1 and I2 are the
interest expenses before taxes under financing plans 1 and 2, t is the income tax rate, and
n1 and n2 are the number of equity shares outstanding under financing plans 1 and 2.
Applying the above equation, we have : (PBIT* - 0)(0,5) = (PBIT* - 1 400 0000(0,5)
2 000 000 1 000 000
Continued……………

0,5(PBIT*)(1 000 000) = 0,5(PBIT*)(2 000 000) -0,5(1 400 000)(2 000 000)
500 000PBIT* = 0,5(1 400 000)(2 000 000)
PBIT* = 2 800 000
ROI – ROE ANALYSIS

• Suppose a firm, Headmount Investments Limited, which requires an investment

outlay of $100 million, is considering two capital structures:
Capital Structure A Capital Structure B
($ in million) ($ in million)
Equity 100 50
Debt 0 50
While the average cost of debt is fixed at 12%, the ROI (defined as PBIT divided by
total assets) may vary widely. The tax rate is 50%.
Based on the above information, the relationship between ROI and ROE under the
two capital structures, A and B is as shown below.
Relationship between ROI and ROE under Capital Structures A and B

Capital Structure A Capital Structure B

ROI 5% 10% 15% 20% 25% 5% 10% 15% 20% 25%
PBIT ($’m) 5 10 15 20 25 5 10 15 20 25
Interest 0 0 0 0 0 5 5 5 5 5
PBT 5 10 15 20 25 0 5 10 15 20
Tax 2,5 5 7,5 10 12,5 0 2,5 5 7,5 10
PAT 2,5 5 7,5 10 12,5 0 2,5 5 7,5 10
ROE 2,5% 5% 7,5% 10% 12,5% 0% 5% 10% 15% 20%
Continued……..

• Looking at the relationship between ROI and ROE we find that:

 The ROE under capital structure A is higher than the ROE under capital structure
B when ROI is less than the cost of debt.
 The ROE under the two capital structures is the same when ROI is equal to to the
cost of debt. Hence the indifference (or breakeven) value of ROI is equal to the
cost of debt.
 The ROE under capital structure B is higher than the ROE under capital structure
A when ROI is more than the cost of debt.
The influence of ROI and financial leverage on ROE is mathematically as follows:
ROE = [ROI = (ROI – r)D/E] (1 – t); where r is the cost of debt, D/E is the debt-
equity ratio, and t is the tax rate.
Continued………

Applying the above equation to Headmount Investments Limited, when its D/E
ratio is 1, we may calculate the value of ROE for two values of ROI, namely, 15% and
20%.
ROI = 15%
ROE = [15 + (15 – 10) 1] (0,5) = 10,0%
ROI = 20%
ROE = [20 + (20 – 10) 1] (0,5) = 15,0%
LEVERAGE ANALYSIS

• Leverage arises from the existence of fixed costs. Operating leverage arises from
the firm’s fixed operating costs such as salaries, rent, depreciation, insurance,
property taxes, and advertising outlays. Financial leverage arises from the firm’s
fixed financing costs such as interest on debt
• Operating Leverage: arises from the existence of fixed operating costs. When a
firm has fixed operating costs, 1% change in sales leads to more than 1% change
in PBIT. For example, consider a firm which is currently selling a product at $1
000 per unit. Its variable costs are $500 per unit and its fixed operating costs are
$200 000. The profit before interest and taxes at two levels of sales, namely, 500
units and 600 units, is as shown below:
Continued………

Sales Sales
Revenues 500 units 600 units
Variable operating costs 250 000 300 000
Fixed operating costs 200 000 200 000
Profit before interest and taxes 50 000 100 000
In the above example, a 20% increase in revenues leads to a 100% increase in profit before
interest and taxes, thanks to the existence of fixed operating costs. Put differently, fixed operating
costs magnify the impact of changes in revenues.
The sensitivity of profit before interest and taxes to changes in sales is referred to as the degree of
operating leverage (DOL), which is formally defined as:
DOL = %change in PBIT = ∆PBIT/PBIT
% change in Q ∆Q/Q
Continued……..

= ∆[Q(P – V)] / Q(P – V) – F = ∆Q(P – V)/Q(P – V) – F

∆Q/Q ∆Q/Q
= Q(P – V) = Contribution
Q(P–V)-F PBIT
Financial Leverage:

• Financial leverage emanates from the existence of fixed expenses. When a firm
has fixed interest expenses, 1% change in profit before interest and taxes (PBIT)
lead to more than 1% change in profit before taxes (or profit after tax or earnings
per share).
• For example, consider the case of Finex Limited, which currently has a PBIT of $50
000. Its fixed interest expenses are $30 000, and its tax rate is 50%. It has 10 000
shares outstanding. The profit before tax, profit after tax, and earnings per share
of Finex Limited at two levels of PBIT, namely, $50 000 and $60 000 are as shown
below:
Continued……

Case A Case B
PBIT $50 000 $60 000
Interest Expense 30 000 30 000
PBT 20 000 30 000
Tax 10 000 15 000
PAT 10 000 15 000
Earnings per share 1 1,50
In the above example a 20% increase in profit before interest and taxes leads to a 50%
increase in profit before taxes, thanks to the existence of fixed interest expenses. Put
differently, fixed interest expense magnifies the impact of changes in PBIT.
Continued……

• The sensitivity of profit before tax to changes in PBIT ir referred to as the degree
of financial leverage (DFL), which is formally defined as:
DFL = % change in PBT = ∆PBT/PBT
% change in PBT ∆PBIT/PBIT
= ∆[Q(P – V) – F – I]/PBT = ∆Q(P – V)PBT = PBIT
∆[Q(P – V) – F]/PBIT ∆Q(P – V)/PBIT PBT
For illustration, let us consider the information on Finex Limited, which currently
has an interest expense of $30 000. The DFL, which is a function of the level of
PBIT at which it is calculated, may be computed for PBIT = $50 000 and PBIT =
$60 000.
Continued….

DFL (PBIT = 50 000) = 50 000 = 2,5

50 000 – 30 000
DFL (PBIT = 60 000) = 60 000 = 2,0
60 000 – 30 000

Combined Leverage or Total Leverage: arises from the existence of fixed operating costs and
interest expenses. Thanks to the existence of these fixed costs, 1% change in revenues leads to
more than 1% change in profit before tax.
The sensitivity of profit before tax to changes in unit sales is referred to as the degree of total (or
combined) leverage (DTL), which is formally defined as:
DTL = % change in PBT = ∆PBT/PBT = ∆[Q(P – V) – F – I]PBT
5 change in Q ∆Q/Q ∆Q/Q
Continued………

= ∆Q(P – V)/PBT = Q(P – V) = Contribution

∆Q/Q PBT PBT
Note that DTL is simply the product of DOL and DFL.
DTL = DOL x DFL = % change in PBIT
% change in sales
= Contribution x PBIT
PBIT PBT
= Contribution
PBT
Continued………

• For example, consider the data for Finex Limited: P = $1 000; V = $500; F = $200 000; and
I = $30 000. DTL, which is a function of the level of output (Q) at which it is calculated,
may be computed for Q = 500 units and Q = 600 units.
DTL (Q = 500) = 500(1 000 – 500)
500(1 000–500)–200 000–30 000
= 250 000 = 12,5
20 000
DTL (Q = 600) = 600(1 000 – 500)
600(1 000-500)-200 000-30 000
= 300 0000 = 4,29
70 000
RATIO ANALYSIS

• Interest Coverage Ratio: also referred to as the times interest earned ratio, is simply defined
as: Profit before interest and taxes
Interest on debt
For example, suppose the most recent profit before interest and taxes for Edgars Limited were
$120 million and the interest burden on all debt obligations were $20 million. The interest
coverage ratio, therefore, would be $120 m/$20 m = 6. What does it imply? It means than even
if PBIT drops by 83⅓%, the earnings of Edgars will cover its interest payment. However the ratio
has the following deficiencies:
1. It concerns itself only with the interest burden, ignoring the principal repayment obligation.
2. It is based on a measure of earnings, not a measure of cash flow.
3. It is difficult to establish a norm a norm for this ratio. How can we say that an interest
coverage ratio of 2, 3, 4, or an other is adequate?
Cash Flow Coverage Ratio:

• This may be defined as: PBIT + Depreciation + Other non cash charges
Interest on debt + Loan repayment instalments
(1 – Tax rate)
For example, consider the following data for David Whitehead Limited:
Depreciation $20 million
PBIT $120 million
Interest on debt $20 million
Tax rate 50%
Loan repayment instalment $20 million
The cash flow coverage ratio for David Whitehead is:
Continued……….

120 + 20 = 3,5
20
20+1-0,5
Note that while calculating the cash flow coverage ratio, the loan
repayment amount in the denominator is adjusted upward for the tax
factor because the loan repayment amount, unlike the interest, is not a
tax –deductible payment.
This ratio is an improvement over the interest coverage ratio in
measuring the debt capacity; it covers the debt service burden fully and
it focuses on cash flows.
Debt Service Coverage ratio:

• Financial institutions which provide the bulk of long-term debt finance judge the
capacity of a firm in terms of its debt service coverage ratio. This is defined as :
DSCR = ∑PATi + DEPi + INTi + Li
∑INTi + LRIi + Li
Where DSCR is the debt service coverage ratio, PATi is the profit after tax for year i,
DEPi is the depreciation for year i, INTi is the interest on long-term loan for year I,
LRIi is the loan repayment instalment for year i, and Li is the lease rental for year i.
For example, consider a project with the following financial characteristics:
Continued………

Year 1 2 3 4 5 6 7 8 9 10
PAT -2,0 10,0 20,0 25,0 30,0 40,0 40,0 50,0 55,0 55,0
DEPN 12,0 10,8 9,72 8,75 7,87 7,09 6,38 5,74 5,17 4,65
INT 17,6 17,6 17,05 14,85 12,65 10,45 8,25 6,05 3,85 1,65
LRI - - 20 20 20 20 20 20 20 20

The DSCR for this project is: 521.17/270,00 = 1,93

Normally, financial institutions regard a debt service coverage ratio of 2 as satisfactory. If
this ratio is significantly less than 2 and the project is otherwise desirable, a term loan of
a longer maturity may be provided. By the same token, if this ratio is significantly more
than 2, the maturity period of the loan may be shortened.
Fixed Assets Coverage Ratio

• This is defined as: Fixed Assets

Term loans
Suppose a firm has fixed assets (net) of $500 million and term loans of $400
million. Its fixed asset coverage ratio will be 1,25 (500/400)
Financial institutions feel comfortable if the fixed asset coverage ratio is at least
1,25
CASH FLOW ANALYSIS

• The cash flow approach establishes the debt capacity by examining the probability of
default. The cash flow approach to assessing debt capacity involves the following steps:
1. Specify the tolerance limit on the probability of default. This reflects the risk attitude
of management. Is it willing to accept a 0%, 5%, 10%, or whatever, probability of
default on its debt commitment?
2. Estimate the probability distribution of cash flows, taking into account the projected
performance of the firm.
3. Calculate the fixed charges by way of interest payment and principal repayment
associated with various levels of debt.
4. Estimate the debt capacity of the firm as the highest level of debt which is acceptable,
given the tolerance limit, the probability distribution, and the fixed charges defined
above.
Example:

• Consider the following information for Ecobank:

Tolerance Limit: The management of the company does not want the likelihood of cash insolvency
to exceed 5%.
Probability Distribution of Cash Flows: Based on current conditions and projected performance, the
management believes that the expected cash flow will be $50 million with a standard deviation of
$30 million. The cash flow would be normally distributed. The initial cash balance of the company
is $1,26 million.
Fixed Charges: The annual fixed charges associated with various levels of debt would be as follows:
Level of Debt Annual Fixed Charges
Up to $5 million $0,25 million for every $1 million debt
Between $5 million and $10 million $0,26 million for every $1 million of debt
Between $10 million and $15 million $0,27 million for every $1 million of debt
Continued………

Debt Capacity: Given the above information the debt capacity may be established as follows:
1. Since the cash flow is normally distributed the following variable has a standard normal
distribution (Z distribution): Cash inflow – Mean value of cash inflow
Standard deviation of cash inflow
2. The Z value corresponding to 5% cumulative probability (which reflects the risk tolerance of
the management) is -1,645.
3. Since μ = $50 m, σ = $30 m, and the Z value corresponding to the risk tolerance limit is -
1,645, the cash available from the operations of the firm to service the debt is equal to X
which is defined as : X - 50 = -1,645
30
This means X = $0,65 million
Continued……….

4. The total cash available for servicing the debt will be equal to :
$0,65 m (cash available from operations)
+$1,26 m (initial cash balance)
= $1,91 m
5. The level of debt that can be serviced with $1,91 million is as follows:
Amount Annual fixed charges
$5,00 million 0,25 x 5,00 = $1,25 million
$2,54 million 0,26 x 2,54 = $0,66 million
$7,54 million $1,91 million
Limitations of Cash Flow Analysis:

• While the cash flow analysis is simple and intuitively appealing, it has the
following limitations:
 Estimating the distribution of the operating cash inflow is difficult, especially for
firms in industries that are changing and volatile.
 The approach seems to be very conservative as it assumes that the firm will
depend only on its cash balance and operating cash inflows, and not rely on
external financing, to service its debt.
 The tolerance limit expresses the subjective preference of management and may
not reflect the interests of shareholders. Management may borrow very little
because it wants to have a negligible probability of default but this may not be in
the interest of shareholders.
COMPARATIVE ANALYSIS

• A common approach to analysing the capital structure of a firm is to compare its debt ratio
with that of other firms. Perhaps the simplest way to do is to compare a firm’s debt ratio to
the average debt ratio of the industry to which the firm belongs. Such analysis assumes
that firms belonging to the same industry are comparable and, on average, they are more
or less operating at their optimal capital structure. However, both the assumptions are
questionable. Firms within the same industry may not be comparable because of
differences in size, capital intensity, product mix, operating risks, tax status, and so on.
Further, because firms try to follow the industry average, the average debt ratio of the
industry may not represent what is optimal for it.
• Controlling for Differences: Since the firms in an industry may differ on factors like
operating risk, profitability, and tax status, it makes sense to control for differences in these
variables. When you control for differences in these variables, you should maximise the
information available from a cross-section of firms drawn from different industries. A
common way to do this is to run a cross-section regression as follows:
Continued……..

Debt – equity ratio = a + b Variance of operating income

+ c Operating profitability + d Tax rate
Once the intercept and coefficients of the regression analysis relation have been
estimated, the recommended debt-equity ratio of a firm can be established by
plugging in the values of the independent variables of that firm.
Cross-section regression analysis captures significantly more information than what a
naïve comparison of a firm’s debt ratio to the industry average does. However, it has
its own limitations which can be quite serious.
 The coefficients of the regression relation tend to be unstable and vary over time.
 The regression relation often explains only a small portion of the differences in
debt ratios across firms.
GUIDELINES FOR CAPITAL STRUCTURE PLANNING

• The capital structure decision is difficult decision that involves a complex trade-off among
several considerations like income, risk, flexibility, control, timing, and so on. Given the
over-riding objective of maximising the market value of a firm, bear in mind the following
guidelines while hammering out the capital structure of the firm.
Avail of the Tax Advantage of Debt: From a point of the company, interest on debt is tax
deductible expense, whereas equity dividend is not. The contribution of a dollar of debt to
firm value is captured in the following formula:
1 – (1 – tc)(1 – tpe)
(1 – tpd)
Where tc is the corporate tax rate, and tpe and tpd aqre personal tax rates on equity and debt
returns.
Empirical evidence suggests that a dollar of debt enhances company value by 10 to 15 paise.
Preserve Flexibility:

• Flexibility implies that the firm maintains reserve borrowing power to enable it to
raise debt capital to respond to unforeseen changes in government policies,
recessionary conditions in the market place, disruption of supplies, decline in
production caused by power shortage or labour unrest, intensification in
competition, And, perhaps most importantly, emergence of profitable investment
opportunities. The timing and magnitude of such developments cannot oten be
forecast easily. Hence the firm must maintain some unused debt capacity as an
insurance against adverse future developments.
• Flexibility is a powerful defence against financial distress and its consequences
which may include bankruptcy. Loss of flexibility and the accompanying liquidity
crisis may adversely affect product market strategies and operating policies and
impair the value of the firm.
Ensure that the Total Risk Exposure is Reasonable:

• Generally the affairs of the firm are, or should be, managed in such a way that the
total risk borne by equity shareholders, which consists of business risk plus financial
risk, is not unduly high. If the firm has a low business risk it can assume a high degree
of financial risk; otherwise not.
Subordinate Financial Policy to Corporate Strategy
To facilitate an integration of financial policies with corporate strategy, Ellsworth argues
that the CEO of the company should:
 Critically examine the assumptions underlying the firm’s financial policies.
 Persuade finance officers to ensure that financial policies subserve corporate strategy.
 Involve operating managers in financial policy discussions.
 Prevent financial policies from becoming corporate goals.
Resort to Timing Judiciously

• While it is very difficult, almost impossible, to achieve perfect timing, thanks to

market uncertainties, the following guidelines may be helpful in improving the
performance of a firm with respect to timing:
 Never be Greedy: If present conditions are favourable for a certain type of
financing, take advantage of it. Driven by greed, do not wait for an even better
possible tomorrow.
 Rely on Long-term Market Relationships: Financial markets seem to follow
certain patterns of behaviour which tend to recur. Even though these patterns
may not be perfectly regular, they have sufficient persistence. They can profitably
be used as general signals, if not as precise markers, of turning points.
Finance Proactively Not Reactively:

• Adi Godrej says: “Raising money at a time of adversity is infinitely more difficult than in
times of prosperity. So raise money when you can, not when you need it”.
Know the Norms of Lenders and Credit Rating Agencies: As a financial manager, keep an
eye on the implications of financing decisions on the rating of your firm’s debt
instruments. The financial factors that rating agencies commonly consider important are:
 Earning power;
 Business and financial risks;
 Asset protection;
 Cash flow adequacy;
 Financial flexibility; and
 Quality of accounting
Issue Innovative Securities:

• Remember that a security may add to the value of the firm if it reallocates risk
from those who are less inclined to bear it to those who are more willing to
assume it, or enhances liquidity, or diminishes agency costs emanating from the
conflict between shareholders, managers, and creditors, or lowers the combined
burden of tax to the issuer and investors, or bypasses ingeniously some
regulatory restriction.
Communicate Intelligently with Investors: To ensure that the intrinsic value of a
company is fully reflected in its stock price, the company should communicate
intelligently with investors. Given the dominant role of ‘lead steers’, the company
should bear in mind the following guidelines while communicating with an efficient
market.
Continued……..

• De-emphasize Creative Accounting. Efforts to artificially inflate reported earning or creatively

manage the bottom line are often futile.
• Cut Lead Steers into Planning Process. Lead steers should be provided information about the
following:
a) Average operating profit over a business cycle from capital already committed to the business,
b) New investments projected in the forseeable future,
c) Expected rate of return over the lives of investment,
d) Target capital structure and financing policy
e) Acquisitions / divesture strategy.
f) International performance, and
g) Management compensation plan.
Empirical evidence suggests that greater disclosure lowers the cost of equity capital.
CHECKLIST FOR THE CAPITAL STRUCTURE DECSION

• The following factors have a bearing on the capital structure decision:

1. Asset Structure: Tangible-intensive firms that have more assets which are
acceptable as security to lenders have higher financial leverage. Intangible-intensive
firms that have fewer assets that are acceptable as security to lenders have lower
financial leverage.
2. Stability of Revenues: Firms whose revenues are relatively stable can assume more
debt compared to firms with volatile revenues.
3. Operating Leverage: Other things being equal, a firm with lower operating leverage
can employ more financial leverage and vice versa.
4. Growth Rate: Rapidly growing firms need more external capital. Since external
equity is costly and it entails dilution of promoter stake, such firms tend to rely more
on debt.
Continued……

5. Profitability: Highly profitable firms tend to use relatively little debt.

6. Taxes: Interest on debt is a tax-deductible expense. Hence, other things being
equal, higher a firm’s tax rate, the greater the incentive to use debt.
7. Control: When management is concerned about dilution of its equity stake in the
firm, it prefers debt to external equity.
8. Attitude of Management: As there is no precise method for determining the
optimal capital structure, management attitude plays an important role. Some
managements are aggressive and willing to use more debt; others are conservative
and use little debt.
9. Attitude of Lenders and Rating Agencies: Apart from what its own analysis suggest,
managements listen to what lenders and rating agencies say. After all, the ability of a
firm to raise debt depends on the attitude of lenders and ratinf agencies.