E5-E6 Core

Chapter-1

Chapter-1 Capital Structure – Planning & Policy

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This can be done only when all those analyzed and balanced. and one has to go beyond the theory. since capital markets are not perfect and the decision has to be taken under imperfect knowledge and risk. long-term debt. and it develops as a result of the financial decisions taken by the financial manager without any formal planning. preference share capital and equity share capital including reserves and surpluses (i. These factors are highly psychological. complex and qualitative and do not always follow accepted theory. The capital structure should be planned generally keeping in ©BSNL. Two similar companies can have different capital structures if the decision makers differ in their judgment of the significance of various factors. Theoretically. With unplanned capital structure. the determination of an optimum capital structure is a formidable task. In practice. Consequently.e. Since a number of factors influence the capital structure decision of a company. Some companies do not plan their capital structure. The board of directors or the chief financial officer (CEO) of a company should develop an appropriate capital structure which is most advantageous to the company. India For Internal Circulation Only 2 . it is being increasingly realized that a company should plan its capital structure to maximize the use of the funds and to be able to adapt more easily to the changing conditions. retained earnings). A totally theoretical model perhaps cannot adequately handle all those factors which affect the capital structure decision. but ultimately they may face considerable difficulties in raising funds to finance their activities. such as debentures. The optimum capital structure is obtained when the market value per share is maximum. the financial manager should plan an optimum capital structure for his company. these companies may also fail to economize the use of their funds. These companies may prosper in the short-run. There are significant variations among industries and among individual companies within an industry in terms of capital structure. the judgment of the person making the capital structure decision plays a crucial part.E5-E6 Core CAPITAL STRUCTURE – PLANNING & POLICY Chapter-1 Introduction: Capital structure refers to the mix of long-term sources of funds.

It should also be possible for the company to provide funds whenever needed to finance its profitable activities. the interests of other groups. society and government. otherwise its use should be avoided. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. Control: The capital structure should involve minimum risk of loss of control of the company. India For Internal Circulation Only 3 . The owners of closely-held companies are particularly concerned about dilution of control. To the point debt does not add significant risk it should be sued. Flexibility: The capital structure should be flexible. should also be given reasonable consideration. It should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. creditors. Approaches to establish appropriate capital structure: The capital structure will be planned initially when a company is incorporated. The financial manager ©BSNL. The initial capital structure should be designed very carefully. The debt capacity of a company depends on its ability to generate future cash flows. Capacity: The capital structure should be determined within the debt capacity of the company and this capacity should not be exceeded. it should generate maximum returns to the shareholders without adding additional cost to them. customers. The equity shareholders.E5-E6 Core Chapter-1 view the interests of the equity shareholders and the financial requirements of a company. A sound or appropriate capital structure should have the following features: Return: The capital structure of the company should be most advantageous. It should have enough cash to pay creditors’ fixed charges and principal sum. However. being the owners of the company and the providers of risk capital (equity) would be concerned about the ways of financing a company’s operations. Subject to other considerations. Risk: The use of excessive debt threatens the solvency of the company. such as employees.

The following are the three most common approaches to decide about a firm’s capital structure: EBIT-EPS approach for analyzing the impact of debt on EPS Valuation approach for determining the impact of debt on the shareholders’ value Cash flow approach for analyzing the firm’s ability to service debt In addition to these approaches governing the capital structure decisions. The company needs funds to finance its activities continuously. the earning per share also increases without an increase in the owners’ investment. Every time when funds have to be procured. is known as financial leverage or trading on equity. the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finances. many other factors such as control. Thus. EBIT-EPS Approach: The use of fixed cost sources of finance. or marketability are also considered in practice. If the assets financed with the use of debt yield a return greater than the cost of debt. One common method ©BSNL. such as debt and preference share capital to finance the assets of the company. India For Internal Circulation Only 4 . financial leverage is an important consideration in planning the capital structure of a company. But the leverage impact is more pronounced in case of debt because (i) the cost of debits usually lower than the cost of preference share capital and (ii) the interest paid on debt is tax deductible. the financial manager weighs the pros and cons of various sources of finance and selects the most advantageous sources keeping in view the target capital structure. flexibility. Because of its effect on the earnings per share.E5-E6 Core Chapter-1 has also to deal with an existing capital structure. The earnings per share also increase when the preference share capital is used to acquire assets. The companies with high level of the earnings before interest and taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders’ equity.

Debt Financing Rs.12.00. (ii) to borrow Rs.12.000 1.250. EPS will increase at a faster rate with a high degree of leverage.56.46.25.56.500 and the tax rate is 50 per cent.250 20.250 1.000 2.000 to finance its investments and is considering three alternative methods of financing – (i) to issue 25.46.3.000 1. EBIT Less: Interest PBT Less: Taxes PAT Less: Preference dividend Earning available to ordinary shareholders Shares outstanding EPS 3.500 1.250 1. However .000 ordinary shares of Rs. the effect on the earnings per share under the three financing alternatives will be as follows: Table: EPS under alternative financing favourable EBIT: Equity Financing Rs. Though the rate of preference dividend is equal to the rate of interest.250 1.10 per share. India For Internal Circulation Only 5 . EPS is high in case of debt financing because interest charges are tax deductible while preference dividends are not.250 1.250 1. Preference Financing Rs.12.250 0 1.10 each.25 3.100 each at an 8 per cent rate of dividend.46.50.46 3.12. The firm wants to raise Rs. If the firm’s earnings before interest and taxes after additional investment are Rs.000 ordinary shares at Rs.000 at 8 per cent rate of interest.00.250 0 1.250 1. if a company is not able to earn a rate of return on its assets higher ©BSNL. (iii) to issue 2.550 20.500 1. Illustration: Suppose that a firm has an all equity capital structure consisting of 100.12.56.2.E5-E6 Core Chapter-1 of examining the impact of leverage is to analyze the relationship between EPS and various possible levels of EBIT under alternative methods of financing.36 The firm is able to maximize the earnings per share when it uses debt financing.36.56.000 1.92.500 1.56.500 preference shares of Rs.000 1. With increasing levels of EBIT.12.550 0 3.500 0 3.

500 1. 75. it ignores the variability about the expected value of EPS.250 0 27. EBIT Less: Interest PBT Less: Taxes PAT Less: Preference dividend Earning available to ordinary shareholders Shares outstanding EPS 75. Investors in valuing the shares of the company consider both expected value and variability.56.75.000 20.000 37. The belief that investors would be just concerned with the expected EPS is not well founded.000 17.27 Preference Financing Rs.000 37.30 Debt Financing Rs.000/. India For Internal Circulation Only 6 .000 37.500 1. ©BSNL. which however.000 0.00. As a result of this.17 It is obvious that under Unfavourable conditions. when the rate of return on the total assets is less than the cost of debt. has some serious limitations as a financingdecision criterion. The major shortcoming of the EPS as a financing-decision criterion is that it does not consider risk. the earnings per share will fall with the degree of leverage.000 0. Limitations of EPS as a Financing decision Criterion: EPS is one of the most widely used measures of the company’s performance in practice.250 1.500 1.000 27. in choosing between debt and equity in practice.500 1. Suppose the firm in illustration above has an EBIT of Rs.000 0 75.000 0.250 20.000 55.e.E5-E6 Core Chapter-1 than the interest rate (or the preference dividend rate).00. debt (or preference financing) will have an adverse impact on EPS.EPS under different methods will be as follows: Table: EPS under alternative financing methods: Unfavourable EBIT: Equity Financing Rs. i.56. 75. sometimes too much attention is paid on EPS.25.500 0 1.000 0 75.46.

©BSNL. or specific. the question of the optimum (appropriate) debt-equity mix boils down to the firm’s ability to service debt without any threat of insolvency and operating inflexibility. In the case of debt-holders.E5-E6 Core Cost of Capital and Valuation Approach: Chapter-1 The cost of source of finance is the minimum return expected by its suppliers. This is generally the case even when taxes are not considered. This leads one to conclude that debt is a cheaper source of funds than equity. but not as cheap as debt. For ordinary shareholders. cost of capital as a criterion for financing decisions and ignoring risk. a firm would always like to employ debt since it is the cheapest source of funds. India For Internal Circulation Only 7 . the rate of dividends is not fixed and the board of directors has no legal obligation to pay dividends even if the profits are made by the company. Thus. The preference share capital is also cheaper than equity capital. while shareholders will have to share the residue only when the company is wound up. using the component. The loan of debt-holders is returned within a prescribed period. the rate of interest is fixed and the company is legally bound to pay interest whether it makes profits or not. Cash flow approach: One of the features of a sound capital structure is conservatism. The expected return depends on the degree of risk assumed by investors. Conservatism is related to the fixed charges created by the use of debt or preference capital in the capital structure and the firm’s ability tp generate cash to meet these fixed charges. Conservation does not mean employing no debt or small amount of debt. A high degree of risk is assumed by shareholders than debt-holders. the tax deductibility of interest charges further reduces the cost of debt. A firm is considered prudently financed if it is able to service its fixed charges under any reasonably predictable adverse conditions. In practice.

Operating cash flows Non-operating cash flows Financial flows Practical considerations in determining Capital Structure: Control Widely-held companies Closely-held companies Flexibility Loan covenants Early repay ability Reserve capacity ©BSNL. The greater the coverage. However. This requires a full cash flow analysis. it is not the average cash inflows but the yearly cash inflows which are important to determine the debt capacity of a company. for determining the firm’s debt policy. the greater is the amount of debt a company can use. Fixed financial obligations must be met when due. which can cover the various adverse phases.E5-E6 Core Chapter-1 One important ratio which should be examined at the time of planning the capital structure is the ratio of net cash inflows to fixed charges (debt-servicing ratio). Components of Cash flows: The cash flows should be analyzed over a long period of time. India For Internal Circulation Only 8 . always. not on an average or in most years but. a company with a small coverage can also employ a large amount of debt if there are not significant yearly variance in its cash inflows and a small probability of the cash inflows being considerably less to meet fixed charges in a given period. The cash flow analysis can be carried out by preparing proforma cash flow statements to show the firm’s financial conditions under adverse conditions such as a recession. It indicates the number of times the fixed financial obligations are covered by the net cash inflows generated by the company. Thus. The expected cash flows can be categorized into three groups.

What do you understand by Capital Structure? 2. How do you derive optimal Capital Structure? 4. What factors do borrowers think are considered by lenders? Borrowing firms’ managers perceive the following factors in order of importance being considered by lenders: (i) (ii) (iii) (iv) (v) (vi) (vii) profitability quality of management security liquidity existing debt-equity ratio sales growth net worth (viii) reserve position (ix) fluctuations in profits QUESTIONS: 1. What are the features of sound Capital Structure? 5. India For Internal Circulation Only 9 . ©BSNL. Describe the common approaches to decide Capital Structure. it may not be possible for a company to borrow whenever it wants./ lenders may analyze a number of characteristics of the borrower before they decide to lend. Is there any need to plan the Capital Structure? If so why? 3.E5-E6 Core Marketability Market conditions Flotation costs Capacity of raising funds Agency costs Chapter-1 In practice.

Chapter-1 10. What is the valuation approach? 8. Narrate the method of Cash flow approach. Explain the components of cash flow. 9.E5-E6 Core 6. 7. India For Internal Circulation Only 10 . Explain EBIT-EPS approach. What are the practical considerations in determining the capital structure? ©BSNL.