CAPITAL STRUCTURE PLANNING:

FINANCING DECISION
 Let’s define it!
 Debt. It consists of borrowed money that is due back to the lender, commonly
interest expense.

 Equity. It consists of ownership rights in the company, without the need to

pay back any investment.

 Cost of Capital. It represents the return a company needs to achieve in

order to justify the cost of a capital project, such as purchasing new
equipment or constructing new building.

 Cost of debt. It is the effective interest rate that a company pay on its debts,
such as bonds and loans.

2
 Cost of Equity. It is the return that a company requires for an
investment or project, or the return that an individual requires for an
equity investment.

 Market Value. The price at which something can be sold.

 Earnings Per Share (EPS). It is a figure describing a public

company’s profit per outstanding share of stock, calculated on a
quarterly or annual basis.

 Weighted Average of Cost Capital (WACC). Is the average after-tax

cost of a company’s various capital sources, including common stock,
preferred stock, bonds and any other long-term debt.

3
 What is Capital Structure?
 Capital structure is the particular combination of debt and equity used a company
to finance its overall operations and growth.

 Its objective is finding an optimum capital structure leading to maximization of the

value of the firm.

 It is synonymously used as financial leverage or financing mix.

 Financial leverage is the extent to which a business firm employs borrowed

money or debts.

4
 The Importance of Designing a Proper Capital Structure

 Value Maximization
- Capital structure maximizes the market value of a firm. Having
a proper designed capital structure, the aggregate value of the
claims and ownership interests of the shareholders are
maximized.

5
 The Importance of Designing a Proper Capital Structure

 Cost Maximization
- Capital structure minimizes the firm’s cost of capital or cost of
financing. By determining a proper mix of fund sources, a firm
can keep the overall capital to the lowest.

6
 The Importance of Designing a Proper Capital Structure

 Increase in Share Price

- Capital structure maximizes the company’s market price of
share by increasing earnings per share of the ordinary
shareholders. It also increases dividends receipt of the
shareholders.

7
 The Importance of Designing a Proper Capital Structure

 Investment Opportunity
- Capital structure increases the ability of the company to find new
wealth-creating investment opportunities. With proper capital gearing it
also increases the confidence of suppliers of debt.
 Growth of the Country
- Capital structure increases the country’s rate of investment and
growth by increasing the firm’s opportunity to engage in future wealth-
creating investments.
8
 The capital structure theories explore the relationship
between the use of debt and equity financing and the value
of the firm. If the use of the debt is profitable then it
increases the value of the firm and vice versa.
 Assumptions of Capital Structure Theories

1) The firm uses only two sources of funds: debt and equity.
2) The effects of taxes are ignored.
3) There is no change in investment decisions or in the firm’s total assets.
4) No income is retained.
5) Business risk is unaffected by the financing mix.
 Capital Structure Theories

Theories of Relevance Theories of Irrelevance

 Net Income Approach  Net Operating Income Approach

 Traditional Approach  Modigliani and Miller Approach

11
 Theories of Capital Structure

 Relevance of Capital Structure

a) Net Income Approach

• According to this approach, a firm can minimize the weighted average cost
of capital (WACC) and increase the value of the firm as well as market price
of equity shares by using debt financing to the maximum possible extent.

• David Durand propounded the net income approach of capital structure in

1952 (Durand 1952).
12
Net Income Approach Assumptions:
1. The cost of debt is less than the cost of equity.
2. There are no taxes.
3. The risk perception of investors is not changed by the use of
debt.

13
b) Traditional Approach

• This approach is the midway of Net Income Approach and Net

Operating Income Approach.

• The traditional approach explains that up to certain point, debt-

equity mix will cause the market value of the firm to rise and
the cost of capital to decline.

14
Traditional Approach Assumptions:

1. The rate of interest on debt remains constant for a certain

period.
2. The expected rate by equity shareholders remains constant or
increase gradually.
3. The WACC first decreases and then increases.

15
 Theories of Capital Structure

 Irrelevance of Capital Structure

a) Net Operating Income Approach

• This theory is developed by David Durand.

• It is the exact opposite of the Net Income (NI) approach.

• Net Operating Income theory is called irrelevant theory since it

assumes that the only capital structure change cannot affect
the cost of capital and value of the firm.
16
Net Operating Income Approach Assumptions:

1. Debt and equity are source of financing.

2. Dividend pay-out ratio is 1.
3. No taxes
4. No retained earnings
5. Constant debt capitalization
6. Constant WACC
7. Difference between firm value and value of debt is value of equity
8. Cost of equity is larger than cost of debt.
17
b) Modigliani and Miller Approach

• This suggests that the valuation of a firm is irrelevant to the capital structure of a
company.

• The Modigliani and Miller Approach further states that the market value of a firm
is affected by its operating income, apart from the risk involved in the investment.

• The theory stated that the value of the firm is not dependent on the choice of
capital structure or financing decisions of the firm.

18
Modigliani and Miller Approach Assumptions:

1. There are no taxes.

2. Transaction cost for buying and selling securities, as well as the bankruptcy cost.
3. There is a symmetry of information. This means that an investor will have access
to the same information that a corporation would and investors will thus behave
rationally.
4. The cost of borrowing is the same for investors and companies.
5. There is no floatation cost, such as an underwriting commission, payment to
merchant bankers, advertisement expenses, etc.

19
 Modigliani and Miller Approach has Two Propositions

 Proposition without taxes

• With the above assumptions of “no taxes”, the capital structure does not
influence the valuation of a firm.

• In other words, leveraging the company does not increase the market value
of the company.

• It also suggests that debt holder in the company and equity shareholders
have the same priority, i.e., earnings are split equally amongst them.

20
 Proposition with taxes

• The MM approach assumes that there are no taxes, but in the real world,
this is far from the truth.

• This approach with corporate taxes does acknowledge tax savings and
thus infers that a change in the debt-equity ratio has an effect on the
WACC (Weighted Average Cost of Capital).

• This means the higher the debt, the lower the WACC. The MM approach
is one of the modern approaches of Capital Structure Theory.

21
 Modigliani and Miller Hypothesis under Corporate Taxes

• M & M hypothesis is identical with the Net Operating Income approach if

taxes are ignored.

• However, when corporate taxes are assumed to exist, their hypothesis is

similar to the Net Income Approach.

• Modigliani and Miller, in their article of 1963 have recognized that the value of
the firm will increase or the cost of capital will decrease with the use of debt
on account of deductibility of interest charges for tax purpose.

22
 Capital Structure Planning and Policy

• Its main objective is to maximize the profits and wealth of the shareholders
and ensures the maximum value of a firm or the minimum cost of capital.

• On the other hand, capital structure planning makes strong balance sheet. It
increases the power of company to face the losses and changes in financial
markets.

23
 Importance Capital Structure Planning and Policy

1) To reduce the overall risk of company

• Adjustments are needed when we make a capital structure to reduce

our overall risk before getting the money from money supplier.

24
 Importance Capital Structure Planning and Policy

2) To do adjustment according to Business

3) Idea generation of new source of fund
Environment

•
• Good planning of capital structure will
Every business will have adjustments in
their different sources of expected amount make versatile to finance manager for
depends on the business environment. getting money from new sources.

25
 Practical Consideration in Determining Capital Structure

1) Financial Leverage

• It occurs when a corporation earns a bigger return on fixed

cost funds than it pays for the use of such funds. It refers to
typical situation in which a firm has fixed charges, securities,
such as preferred stock and debentures, and its return on
investment.

26
 Practical Consideration in Determining Capital Structure

2) Growth and Stability of Sales

• Stability of sales ensures that the firm will not face any
difficulty in meeting its fixed commitments of interest payment
and repayments of debt.

27
 Practical Consideration in Determining Capital Structure

3) Cost of Capital

• Cost of capital refers to the minimum return expected by its

suppliers. The expected return depends on the degree of risk
assumed by shareholders than debt-holders.

28
 Practical Consideration in Determining Capital Structure

4) Risks

• Business risk and financial risk are the two types to be

considered while planning structure of a firm.

• Business risk can be internal as well as external.

29
 Practical Consideration in Determining Capital Structure

5) Cash Flow

• One of the features of a sound capital structure is

conservation.

• Conservatism is related to the assessment of the liability for

fixed charges, created by the use of debt or preference
capital in the capital structure in the context of the firm’s
ability to generate cash to meet these fixed charges.

30
 Practical Consideration in Determining Capital Structure

6) Control

• Whenever additional funds are required by a firm, the

management of the firm wants to raise the funds without
any loss of control over the firm.

31
 Practical Consideration in Determining Capital Structure

7) Flexibility

• Flexibility means the firm’s ability to adapt its capital

structure to the needs of the changing conditions.

• The capital structure of a firm is flexible if it has no difficulty

in changing its capitalization or sources of funds.

32
 Capital Structure: Financing Decision
⋆ Financing Decision 1. How much finance is
 a decision which is needed?
concerned with
the amount of 2. From where such
finance to be finance can be
raised from procured?
various long term
sources of funds.
3. In what proportion?

33
 Capital Structure: Financing Decision
⋆ Financing Decision Sources of Long-term
 a decision which is Funds
concerned with the amount
of finance to be raised from
various long term sources of
funds.
Debt Preferenc
Equity es
1. How much finance is needed?
2. From where such finance can be procured?
3. In what proportion?

34
Capital Structure:

⋆ Refers to the ⋆ It is the

composition of combination of
capital or make capitals from
up of its
capitalization and different
its all long-term sources of
capital resources. finance.

35
36
 Equity Shares only
Equity &
You Preference Shares
Company (Finance Manager) only
Capital Equity &
Optimum Structure
Capital Debenture only
Maximum Structure Cost of Capital is Equity Shares,
EPS/MPS Minimum Preference Shares
& Debentures
37
Formula: EBIT – EPS – MPS Analysis
Particulars
Sales xxx
(-) Variable Cost (xx)
Contribution xxx
(-) Fixed Cost (xx)
Earnings Before Interest & Tax (EBIT) xxx
(-) Interest (xx)
Earning Before Tax (EBT) xxx
(-) Tax (xx)

38
Formula: EBIT – EPS – MPS Analysis

Earning After Tax (EAT) xxx

(-) Preference Dividend (xx)
Earning Available to Equity Shareholders (EASH) xxx
÷ No. of Equity Shares xx
Earning Per Share (EPS) xxx
x P/E (Price Earning) Ratio xx
Market Price per Share (MPS) xxx

39
Formula: EPS Analysis
EPS = EASH / No. of Equity Shares
Formula: P/E Ratio
P/E Ratio = MPS / EPS

Formula: MPS Analysis

MPS = EPS x P/E Ratio

40
 Optimum Capital Structure

Maximum Value of the Firm Minimum Cost of Capital

Maximization of Equity
Shareholders Wealth

Maximum EPS-MPS
41
 EBIT-EPS Analysis
1. FM 211 Company has 600,000 equity shares of
P10 each. The company wants to raise another
300,000.

These are the different financial plans:

a. All debentures carrying 10% interest Tax rate is 50%
b. All equity Calculate EPS if EBIT is
c. 200,000 in equity shares and 100,000 in a. 135,000
debentures carrying 10% interest b. 108,000
d. 100,000 equity shares and 200,000 in 10%
preference shares
42
Solution: Calculation of EPS at different plans
a. When EBIT is 135, 000
Particulars a. All Debentures b. All Equity c. Equity (200,000) d. Equity (100,00)
(300,000 w/ 10% (300,000) Debt (100,000 w/ 10% Pref. Sh. (200,000 in 10%
interest) interest) Pref. Sh. Div.)
EBIT 135,000 135,000 135,000 135,000

Less: Interest 30,000 10,000

EBT 105,000 135,000 125,000 135,000

Less: Tax (50%) 52,500 67,500 62,500 67,500

EAT 52,500 67,500 62,500 67,500

Less: Pref. Dividend 20,000

EAESH 52,500 67,500 62,500 47,500

43
Solution: Calculation of EPS at different plans
a. When EBIT is 135, 000
Particulars All Debentures All Equity Equity (200,000) Equity (100,00)
(300,000 w/ 10% (300,000) Debt (100,000 w/ 10% Pref. Sh. (200,000 in 10%
interest) interest) Pref. Sh. Div.)
EAESH 52,500 67,500 62,500 47,500

÷ No. of equity shares 60,000 90,000 80,000 70,000

EPS 0.875 0.75 0.781 0.679

The option which has the maximum EPS will be

selected.
44
Solution: Calculation of EPS at different plans
b. When EBIT is 108, 000
Particulars All Debentures All Equity Equity (200,000) Equity (100,00)
(300,000 w/ 10% (300,000) Debt (100,000 w/ 10% Pref. Sh. (200,000 in 10%
interest) interest) Pref. Sh. Div.)
EBIT 108,000 108,000 108,000 108,000

Less: Interest 30,000 10,000

EBT 78,000 108,000 98,000 108,000

Less: Tax (50%) 39,000 54,000 49,000 54,000

EAT 39,000 54,000 49,000 54,000

Less: Pref. Dividend 20,000

EAESH 39,000 54,000 49,000 34,000

45
Solution: Calculation of EPS at different plans
b. When EBIT is 108, 000
Particulars All Debentures All Equity Equity (200,000) Equity (100,00)
(300,000 w/ 10% (300,000) Debt (100,000 w/ 10% Pref. Sh. (200,000 in 10%
interest) interest) Pref. Sh. Div.)
EAESH 39,000 54,000 49,000 34,000

÷ No. of equity shares 60,000 90,000 80,000 70,000

EPS 0.65 0.60 0.613 0.486

The option which has the maximum EPS will be

selected.
46
 LEVERAGE ANALYSIS
Meaning & Concept:
⋆ Leverage is used to describe the ability of a
firm to use fixed-cost assets or funds to
increase the return to its equity
shareholders.

47
 LEVERAGE ANALYSIS
Leverage is:

Gaining larger
benefits by using a
lesser amount of
force.

48
Concept of Leverage
Use of Leverage in FM

In helps us to understand
How to do MORE with LESS?

49
 Analysis of Leverage

Business and Types of Leverage

Financial Risk
1. Operating Leverage
2. Financial Leverage
3. Combined Leverage
50
Chart Showing Operating, Financial, and Combined
Leverage
Profitability Statement
Particulars
Sales xxx
(-) Variable Cost (xx)
Contribution xxx
(-) Fixed Cost (xx)
Operating Leverage
Earnings Before Interest & Tax (EBIT) xxx
(-) Interest (xx)
Earning Before Tax (EBT) xxx
Financial Leverage
(-) Tax (xx)

51
Formula: Leverage Analysis

Earning After Tax (EAT) xxx

(-) Preference Dividend (if any) (xx)
Earning Available to Equity Shareholders (EASH) xxx
Combined
÷ No. of Equity Shares xx
Leverage
Earning Per Share (EPS) xxx

52
 Types of Leverage
Operating Leverage
⋆ Taking advantage of
operations of business, i.e
Operating fixed cost
⋆ By increasing the SALES
by a certain %
Formulas:
DOL = % Change in EBIT / %
Change in SALES
DOL = Contribution / EBIT
Financial Leverage
⋆ Taking advantage of the
financial structure of
business i.e. fixed cost of
finance – interest
⋆ By increasing the EBIT by
a certain percentage
Formulas:
DFL = % change in EPS / %
change in EBIT
DFL = EBIT / EBT
53
Combined Leverage
⋆ Taking advantages of both
operations and financial
structure of business.
⋆ By increasing the SALES
by a certain percentage
Formulas:
DCL = % change in EPS / %
change in SALES
DCL = Contribution/ EBT
DCL = DOL x DFL
 How to calculate the % of change?
Particulars: % of change = New Figure – Old Figure
Sales = 100,000 to increase by 50% Old Figure
V. Cost = 60% Calculate the % change:
Fixed Cost = 10,000 % change in SALES = 150,000 – 100,000
100,000
Particulars Year 1 Year 2 = 50,000 / 100,000
Sales 100,000 150,000 = 0.5 / 50% (SALES)
Variable Cost (60%) 60,000 90,000
% change in EBIT = 50,000 – 30,000
Contribution 40,000 60,000
30,000
Fixed Cost 10,000 10,000 = 20,000 / 30,000
EBIT 30,000 50,000 = 0.67 / 67% (EBIT)
54
 Now, let us calculate operating leverage (DOL):
Calculate the % change: DOL = % change in EBIT
% change in SALES = 150,000 – 100,000 % change in SALES
100,000 DOL = 67 / 50 = 1.3 times
= 50,000 / 100,000
= 0.5 / 50% (SALES) DOL = Contribution / EBIT

% change in EBIT = 50,000 – 30,000 DOL = 40,000 / 30,000 = 1.3 times

30,000
= 20,000 / 30,000
It means that if you increase the sales 50%
= 0.67 / 67% (EBIT)
then you can see a 1.3 percent change in
EBIT.
55
 Now, let us calculate financial leverage (DFL):
Particulars:
EBIT = 5,000 increase to 100% Shares = 10,000 @ P10 each
Debt = 40,000 w/ 10% interest Tax Rate = 50% % change in EBIT = 1/ 100%
% change in EPS = 5 / 500%
Scenario 1 Scenario 2

EBIT 5,000 10,000

DFL = % change in EPS
% change in EBIT
Interest 4,000 4,000

EBT 1,000 6,000

% change in EPS = New Figure – Old Figure
Old Figure
Tax Rate (50%) 500 3,000
% change in EPS = 3 – 0.5 / 0.5 = 5 times or 500%
EASH 500 3,000
DFL = 500% / 100% = 5 times
/ no. of shares 1,000 1,000 DFL = EBIT / EBT = 5,000 / 1000 = 5 times
EPS 0.5 3
Implication / Significance: If EBIT increases by 100%
56
that means EPS will increase by 500% or 5 times.
 Now, let us calculate combined leverage (DCL):
DCL = % change in EPS DCL = DOL x DFL
% change in Sales = 1.3 x 5
= 6.5 times
= 500% / 50%
= 10 / 1000%

57
 Activity 1: Leverage
1. A firm details are as under:
Sales – 240,000
Variable Cost – 50%
Fixed Cost – 100,000
Tax rate – 50%
It has a borrowed 100,000 with
10% interest per annum and its
equity share capital is 100,000 @
P10 each.
Calculate:
a. Operating Leverage
(Contribution / EBIT)
b. Financial Leverage (EBIT/EBT)
c. Combined Leverage (OL x FL)
d. If the sales increases by
60,000; what will be the new
EBIT?
58
 Solution:
a. Prepare the income statement and DOL

Particulars Interest (100k x 10%) 10,000 DOL = Contribution / EBIT

Sales 240,000 EBT 10,000 = 120,000 / 20,000
Variable Cost (50%) 120,000 DOL= 6 times
Tax (50%) 5,000

Contribution 120,000 EAESH 5,000

It means that if sales
Fixed Cost 100,000 / No. of Equity Shrs. 10,000 increases by 1/100%, the
EBIT 20,000
EBIT will increase by 6 times
EPS 0.5 or 50%
or 600%.

59
 Solution:
b. Financial Leverage

Particulars Interest (100k x 10%) 10,000 DFL = EBIT / EBT

Sales 240,000 EBT 10,000 = 20,000 / 10,000
Variable Cost (50%) 120,000 DFL= 2 times
Tax (50%) 5,000

Contribution 120,000 EAESH 5,000

It means that if an EBIT
Fixed Cost 100,000 / No. of Equity Shrs. 10,000 increases by 1, EPS will
EBIT 20,000
increase 2 times.
EPS 0.5 or 50%

60
 Solution:
c. Financial Leverage
DCL = OL x FL
Particulars Interest (100k x 10%) 10,000 =6x2
Sales 240,000 EBT 10,000 DCL= 12 times
Variable Cost (50%) 120,000 Tax (50%) 5,000
DCL = Contribution / EBT
Contribution 120,000 EAESH 5,000 = 120,000 / 10,000
Fixed Cost 100,000 / No. of Equity Shrs. 10,000 DCL= 12 times
EBIT 20,000 EPS 0.5 or 50%

61
 Solution:
d. If the sales increases by 60,000; what will be the new EBIT?
Particulars Old F.g New F.g 1. % change in Sales = New F.g – Old F.g
Sales 240,000 300,000 Old F.g
= 300,000 – 240,000 / 240,000
2. DOL = change in EBIT/ & change in Sales = 60,000 / 240,000
6 = △EBIT / 25 = 0.25 / 25%
△EBIT = 6 x 25
= 150%
Increase in EBIT = 240,000 x 150% 3. New EBIT = 240,000 + 360, 000
= 360,000 = 600,000

62
 Further explanation:
⋆ If no fixed point, there is
no leverage
⋆ If a man will move the
object without a fixed
point then there is no
leverage in it.
⋆ There has to be a fixed
point to gain an
advantage
⋆ ⋆
To run the business, you
have to incur the
operating expenses.
⋆ How does business get
advantage and how does it
get leverage to operating
expenses? It is though the
FIXED COST.
⋆ It doesn’t move with the
level of activity., it doesn’t
move with the revenue, it
doesn’t move with the sales.
As the sales is increasing and
increasing, the EBIT will
increase more than the sales
because the fixed cost is
constant.
63
Example:
⋆ You are a teacher, so if you
have a classroom, and you
are paying P5,000 rent in a
classroom, if you are
teaching 1 student or
teaching 50 students, the
P5,000 rent will be the same
but as you increase your
sales and increase the
students, you will get more
fees and your EBIT will
increase rapidly more than
the sales.