Form of Capital:

Capital Structure
Terminologies

Capitalization

Capital
Structure

Financial
Structure
Capitalization Balance Sheet

Total amount Current Liabilities Current Assets

of
(in ) Debt
issued by a
Preference Shares
company Fixed Assets

Equity Shares

Retained Earnings
 Balance Sheet

Current Liabilities Current Assets

Debt

Capital Preference Shares

Structure Fixed Assets

( % mix) Equity Shares

Retained Earnings
 Balance Sheet

Current Liabilities Current Assets

Debt
Financial
Structure Preference Shares
Fixed Assets
( % mix )
Equity Shares

Retained Earnings
What does it
Conclude !!
Capital Structure =
Financial Current
Structure liabilities
Importance of Capital Structure:
 t s a s a
Ac Reflects
n a ge m
ma the
t o o l
ent firm’s
to r
i ca strategy
I nd r i s k
of e of
fi l
pro firm
t he
 Optimal Capital Structure
Capital structure or combination of debt and equity that
leads to maximum value of firm.

Maximises value of company and wealth of owners.

Minimises the company’s cost of capital.

 Considerations to be kept in mind while
maximising value of firm:

Company should make maximum possible use of

leverage to increase EPS and market value of firm.

Company should take advantage of tax leverage

Firm should avoid undue financial risk attached with

use of increased debt financing.

Capital structure should be flexible.

The mix of debt, preferred stock, and
common stock the firm plans to use over the
long-run to finance its operations.
Factors determining capital
structure
 A company is considering 4 different plans to
finance its total project cost of Rs 5,00,000
Plan I Plan II Plan III Plan IV

Equity(Rs. 10 5,00,000 2,50,000 2,50,000 2,50,000

per share)

8% Preference - 2,50,000 - 1,00,000

Shares

Debt (8% - - 2,50,000 1,50,000

Debenture)

5,00,000 5,00,000 5,00,000 5,00,000

 Plan I Plan II Plan III Plan IV
EBIT 1,00,000 1,00,000 1,00,000 1,00,000

Less: Interest - - 20,000 12,000

on Debentures
EBT 1,00,000 1,00,000 80,000 88,000

Less: Tax @50% 50,000 50,000 40,000 44,000

Earning after 50,000 50,000 40,000 44,000

Interest and
Tax
Less: NIL 20,000 NIL 8,000
Preference
Dividend
Earning available 50,000 30,000 40,000 36,000
for
eq.Shareholders
(A)
No. of Equity 50,000 25,000 25,000 25,000
Shares(B)
EPS(A/B) 50,000/50,000 30,000/25,000 40,000/25,000 36,000/25,000
= Rs.1per share =Rs.1.20per share =Rs.1.60per share =Rs.1.44per share
PRINCIPLES OF CAPITAL
STRUCTURE
COST
PRINCIPLE

CONTROL RISK
PRINCIPLE PRINCIPLE

FLEXIBILITY TIMING
PRINCIPLE PRINCIPLE
 Financial Break-Even Point
 Level of EBIT which is just equal to pay the total financial charges.

 At this point EPS = 0.

 Critical point in planning capital structure of firm.

 If EBIT < financial break even point, then debt and preference share capital
should be reduced in capitalization.

 If EBIT> financial break even point more of fixed cost may be inducted in
capital structure.
 When capital
structure consists •
Financial Break Even Point
of debt and equity
share capital and = Fixed Interest Charges
no preference
share capital

When capital
structure consists • Financial break even point=
I+ Dp
of equity share • (1-t)
capital, preference • here, I = fixed interest charges
share capital and • Dp = preference dividend
• t = tax rate
debt
 Point of Indifference/ Range of Earnings

 It is EBIT level at which

EPS remains the same ;

irrespective of different alternatives of debt-equity mix.

 At this level of EBIT,

rate of return on capital employed = cost of debt.

 Calculation of Point of Indifference (algebraically):
(X-I1) (1-T) – PD = (X-I2) (1-T)- PD
S1 S2
WHERE, X = point of indifference,
I1 = interest under alternative financial plan 1,

I2 = interest under alternative financial plan 2,

T= tax rate,

S1 = no of equity shares under financial plan1,

S2 = no of equity shared under financial plan 2,

PD= preference dividend.

A project under consideration by your company requires a
capital investment of 60 lakhs. Interest on loan 10 % p.a
and tax rate 50%. Calculate point of indifference for the

project, if debt equity ratio is 2:1.

As debt equity ratio is 2:1. So, Company has two alternatives :
(i) Raising entire amount by issue of share capital and no debt.
(ii) Raising 40 lakh by way of debt and 20 lakh by issue of equity
share capital.
Calculation of point of indifference:
(X-I1) (1-T) – PD = (X-I2) (1-T)- PD
S1 S2
I1 = 0 , I2 = 40* 10% = 4 , tax rate = 50 % or .5 , S1= 60, S2 = 20
now substitute the values,
(X-0) (1-0.5) – 0 = (X-4) (1-0.5) – 0
60 20
20 (.5X) = 60 (.5X-2)
10X = 30X-120
X=6
Thus, EBIT at point of indifference is 6 lakhs.
 Graphically :
12

10

8
ebt
D
ity
6 Equ Plan 1
Plan 2
EPS (Rs.)

2
Indifference point
0
1 2 3 4 5 6 7 8 9 10

EBIT (Rs. In lakhs)

Risk-Return Trade Off
Capital mix involves two types of risks:
1. Financial Risk
2. Non-Employment of Debt Capital
Risk (NEDC)
 Financial Risk Sales

Operating (–) Variable costs

• Debt causes financial Leverage Contribution
risk ! (–) Fixed costs
EBIT / Profit
• The use of debt (–) Interest expense
financing is referred to Financial EBT
as financial leverage. Leverage (–) Taxes
EAT

• Financial leverage (-) Preference dividend

Earnings available for
measures Financial
equity Shareholders
risk.
 Non-Employment of Debt Capital
(NEDC) Risk

 No advantage of Financial leverage.

 Loss of control by issue of more and more

Equity.
 Higher Floatation Cost.
Strike a balance (trade off) between
the financial risk
and
Risk of non-employment of debt capital
to increase
Firm’s Market Value.
 CAPITAL GEARING
• The term "capital gearing" or "leverage" normally refers to the proportion

of relationship between equity share capital including reserves and

surpluses to preference share capital and other fixed interest bearing

funds or loans.

• It is the proportion between the fixed interest or dividend bearing funds

and non fixed interest or dividend bearing funds.

• Equity share capital includes equity share capital and all reserves and

surpluses items that belong to shareholders. Fixed interest bearing funds

includes debentures, preference share capital and other long-term loans.

 HOW TO CALCULATE

Formula of capital gearing

ratio:-
[Capital Gearing Ratio = Equity
Share Capital / Fixed Interest
Bearing Funds]
 EXAMPLE
1992 1993
EQUITY SHARE 5,00,000 4,00,000
CAPITAL
RESERVES AND 3,00,OOO 2,00,000
SURPLUSES
LONG TERM 2,50,000 3,00,000
LOANS
6% 2,50,000 4,00,000
DEBENTURES
 CALCULATION

Capital Gearing Ratio

1992 = (500,000 + 300,000) / (250,000 + 250,000)
= 8 : 5 (Low Gear)
1993 = (400,000 + 200,000) / (300,000 +400,000)
=6 : 7 (High Gear)
It may be noted that gearing is an inverse ratio to the
equity share capital.
Highly Geared------------Low Equity Share Capital
Low Geared---------------High Equity Share Capital
 SIGNIFICANCE

Capital gearing ratio is important to the

company and the prospective investors. It
must be carefully planned as it affects the
company's capacity to maintain a uniform
dividend policy during difficult trading periods.
It reveals the suitability of company's
capitalization.
REASONS FOR CHANGE IN CAPITAL
STRUCTURE :-
To restore balance in financial plan

To simplify the capital structure

To suit investors needs

To fund current liabilities

To write-off the debts

 To capitalise retained earnings

To clear default on fixed cost

structures

To fund accumulated dividends

To facilitate merger and expansion

To meet legal requirements

1.) Restoring
balance in
financial
plan A company can adjust
its capital structure as
according to needs.

So as to maintain a
balance in financial
plan and ease out the
tension and strain
2.) Simplify the capital structure
When market conditions are
favorable various securities
at different point of time can
be consolidated.

This will lead to simplification

of financial plan
3.)To suit the need of investors
To make the investment more
attractive especially when the
shares are limited

due to wide fluctuations in market

the company may change

capitalisation to suit the needs of
investors.
4.)To fund current liabilities
There may be need of converting
short term obligations into long
term obligations

Or vice versa

When the market conditions are

favorable
5.)To write off deficit
A company may need to re-organize its
capital by reducing book value of its
liabilities and assets to its real values

As when the book value of assets are over-

valued

Or when there are accumulated losses

So as to make company legally payable for

dividends to its shareholders
6.)To capitalise retained earnings

Maintain a balance
Company may
between preference
capitalise retained
To avoid over- shares and equity
earnings by issuing
capitalisation shares and equity
bonus shares out of
shares and
it
debentures
7.)To clear defaults on fixed cost securities:-

When the company is It may offer them

not in a position to certain
pay interest on securities(equity
debentures or to shares, preference to clear default
repay them on shares or new
maturity debentures)
 8.)To fund accumulated dividend
When its time to pay fixed dividends to its preference
shareholders

Or when the preference shares are due for redemption

And the company do not have sufficient funds

The company may prefer to issue new shares in lieu

9.)To facilitate merger and expansion

To facilitate merger and

expansion

Companies may be required to

re adjust its capital structure
10.)To meet legal requirements

To meet the legal requirements

It is necessitated to meet the changes in

various legal requirements

As and when took place

Financial Distress and Capital Structure

• Financial risk increases when firm uses more debt;

it may not be able to pat fixed interest and runs into bankruptcy.

• Firms using more equity don't face this problem.

• Use of debt provides tax benefit but bankruptcy costs work

against the advantage.

• When firm raises debt, suppliers put restrictions in agreement

resulting to less freedom of decision making by management
called agency cost.
 Pecking Order Theory
• This theory was suggested by DONALDSON in 1961.
• It was modified by MYERS in 1984.

According to Donaldson,

o Firm has well defined order of preference for raising finance.

o When firm need funds it will rely on internally generated funds.

o This order of preference is so defined because internally

generated funds have no issue costs.
 Cost of
internally
generated
funds is
lowest.

Servicing of
Raising of debt
debt capital is
is cheaper
relatively less
source of
as compared to
finance.
equity
Theory
presumptions

Raising of debt
Issue of new
through term
equity capital
loan is cheaper
involves heavy
than issuing
issue cost.
bonds.
 Dividend policy is
stickily

Proposes
of pecking
There is
Issue of new preference for
equity for raising internally

order
additional funds generated funds
is considered as to external
a last resort financing

theory

If external
financing is
needed, debt is
preferred to
equity
 According to modified pecking order
theory,
o Order of preference for raising funds arises because of
asymmetric information between market and firm.

o Firm may prefer internal funds and then raising of debt

as compared to issue of new equity share capital.
BY NAGALAKSHMI