CAPITAL STRUCTURE CREATION

FOR A COMPANY

Dr. Sandeepa Kaur

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 Definition

• Capital structure of a company

refers to the composition of its
capitalisation and it includes all long
term sources i.e., loans, reserves,
shares and bonds.

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 Factors affecting Capital Structure
• INTERNAL • EXTERNAL
• Financial Leverage • Size of the company
• Risk • Nature of the industry
• Growth and stability • Investors
• Retaining control • Cost of Capital
• Cost of Capital • Legal requirements
• Cash Flows • Period of finance
• Flexibility • Level of Interest rate
• Purpose of Finance • Level of business activity
• Asset Structure • Availability of funds
• Taxation Policy
• Level of stock prices
• Conditions for the capital market
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OPTIMAL CAPITAL STRUCTURE
• The OCM can be defined as “that capital structure or combination of debt
and equity that leads to the maximum value of the firm.
• OCM maximizes the value of the company and hence the wealth of its
owners and minimize the company’s cost of capital.
• The following consideration should be kept in mind while maximizing the
value of the firm in achieving the goal of the optimal capital structure:
• If ROI > the fixed cost of funds, the company should prefer to raise the
funds having a fixed cost such as debentures, loans and PSC. It will
increase EPS and MV of the firm.
• If debt is used as a source of finance, the firm saves a considerable amount
of payment of tax as interest is allowed as deductible expenses in
computation of taxes.
• It should also avoid undue financial risk attached with the use of increased
debt financing.
• The capital structure should be flexible.
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Point of indifference / Range of earnings
• The earnings per share, ‘equivalent point’ or ‘point
of indifference’ refers to that EBIT, 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 known as
the break-even level of EBIT for alternative
financial plans.

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 Capital Gearing

• CG means the ratio between the various

types of securities in the capital structure of
the company. A company is said to e high-
gear when it has proportionately
higher/larger issue of Debt and PS for
raising the LT resources. Whereas low-gear
stands for a proportionately large issue of
equity shares.

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Leverage
Leverage-an Increased means of accomplishing some purpose:
• In financial management, it is the firms ability to use fixed
cost assets or funds to increase the returns to its owners;
• Financial leverage- the use of long term fixed income
bearing debt and preference share capital along with the
equity share capital is called financial leverage or trading
on equity
• A Firm is known to have a favourable leverage if its
earnings are more than what debt would cost. On the
contrary, if it does not earn as much as the debt costs then it
will be known as an unfavourable leverage.

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 Impact of financial leverage
• When the difference between the earnings from assets
financed by fixed cost funds and cost of these funds
are distributed to the equity stockholders, they will
get additional earnings without increasing their own
investment. Consequently, the EPS and the Rate of
return on ESC will go up.
• On the contrary, if the firm acquires fixed cost funds
at a higher cost than the earnings from those assets
then the EPS and return on equity capital will
decrease.
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Significance of financial leverage
 Planning of capital structure
 Profit planning

Limitations of FL/ trading on equity

 Double-edged weapon

 Beneficial only to companies having stability

in earnings
 Increases risk and rate of interest

 Restriction from financial instruments

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Operating leverage

Operating leverage results from the presence of fixed

costs the help in magnifying net operating income
fluctuations flowing from small variations in revenue.
The changes in sales are related to changes in the
revenue. The fixed costs do not change with the
changes in sales, any increase in sales, FC
remaining the same, will magnify operating revenue
OL shows the ability of a firm to use fixed operating
cost to increase the effect of change in sales
and the charges in fixed operating income.
Combined leverage
 The OL affects the income which is the result
of production. On the other hand, FL is the
result of financial decisions. The CL focuses
attention on the entire income of the concern
 This leverage shows the relationship between
a change in sales and the corresponding
variation in taxable income.
Working capital leverage
This leverage measures the sensitivity of ROI
of changes in the level of current assets.
FACTORS INFLUENCING
1. CONTROL INTERESTS
 According to this factor, at the time of preparing capital
structure, it should be ensured that the control of the
existing shareholders (owners) over the affairs of the
company is not adversely affected. If funds are raised by
issuing equity shares, then the number of company’s
shareholders will increase and it directly affects the control
of existing shareholders. In other words, now the number of
owners (shareholders) controlling the company increases.

2.RISKS
 The economy where a firm conducts business is also
subject to unforeseen risks. In the contemporary
business world, size no longer assures economic
survival. Therefore, finance executives attempt to
consider every possibility imaginable to mitigate
negative economic events.
3.TAX CONSIDERATION
 Debt payments are tax deductible. As such, if a company's tax rate is
high, using debt as a means of financing a project is attractive because
the tax deductibility of the debt payments protects some income from
taxes.

4.COST OF CAPITAL
 Cost of capital determines the type of securities to be issued. During
depressions it is better to raise capital structure through preference
shares and debentures and during boom equity shares are better.

5.FLEXIBILITY
 The firm while deciding the capital structure shall ensure flexibility in
its capital structure. The capital structure should be such that it
always provides scope for raising funds through debts.
 6.INVESTORS ATTITUDE
Attitudes of investors is another factor which determines the equities
to be issued. The investors may be venturesome or cautious or less
cautious. Equity shares can best to be invested to investors who are
venturesome because they are prepared to take risks.

 7.LEGAL PROVISIONS
While determining capital structure the company should take care of
the relevant provisions of various law framed by the government
from time to time. It should also take case of norms set by financial
institutions ,SEBI , stock exchange etc.
8. GROWTH RATE
 Firms that are in the growth stage of their cycle typically finance that
growth through debt, borrowing money to grow faster. The conflict
that arises with this method is that the revenues of growth firms are
typically unstable and unproven. As such, a high debt load is usually
not appropriate.

9.MARKET CONDITIONS
 Market conditions can have a significant impact on a company's
capital-structure condition. Suppose a firm needs to borrow funds for a
new plant. If the market is struggling, meaning investors are limiting
companies' access to capital because of market concerns, the interest
rate to borrow may be higher than a company would want to pay. In
that situation, it may be prudent for a company to wait until market
conditions return to a more normal state before the company tries to
access funds for the plant.
10.PROFITABILITY
 While deciding or planning capital structure ,the firm should keep the
objective of maximizing the shareholders wealth. The firm shall
work out proper EBIT EPS analysis. Then only it can select that
combination which gives highest value of EPS for a given level of
EBIT.

11. FLOATATION COSTS

 Floatation costs are those expenses which are incurred while issuing
securities (e.g., equity shares, preference shares, debentures, etc.).
These include commission of underwriters, brokerage, stationery
expenses, etc. Generally, the cost of issuing debt capital is less than the
share capital. This attracts the company towards debt capital.
12.COST OF DEBT
 The capacity of a company to take debt depends on the cost of debt. In case
the rate of interest on the debt capital is less, more debt capital can be
utilized and vice versa.

13. COST OF EQUITY CAPITAL

 Cost of equity capital (it means the expectations of the equity shareholders
from the company) is affected by the use of debt capital. If the debt capital
is utilized more, it will increase the cost of the equity capital. The simple
reason for this is that the greater use of debt capital increases the risk of
the equity shareholders.

14.GOVERNMENT POLICIES
 Capital structure is also influenced by government regulations. For
instance, banking companies can raise funds by issuing share capital alone,
not any other kind of security. Similarly, it is compulsory for other
companies to maintain a given debt-equity ratio while raising funds.