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Chapter III Capital Structure Planning

 Capital structure refers to the mix of long term sources of funds like
debentures, term loans, preference capital and equity capital including
retained earnings.

 When a business firm makes a capital investment, need arises for raising

 A demand for raising funds generates a new capital structure when a decision
needs to be taken on the amount and modes of finance.

 The financing decision involves an analysis of the existing capital structure
and the factors governing the proposed financing decision.

 The use of debt along with the owners’ equity in the capital structure is
referred to as the financial leverage or trading on equity.

Quote: “As the supplier of debt (i.e., lender) has limited participation in the profits of
the company, the lender needs protection in earnings and protection in values
represented by owners’ equity” – Waterman Merwin H., in his article ‘Trading
on equity’ in Essays on Business Finance, published in 1953.

 The debt-equity mix has implications for the shareholders in terms of their
earnings and risk, which in turn affects the cost of capital and the market
value of the firm.

Note: While making a capital structure decision, the dividend policy of the
company should also be considered.

in equity proposes to raise another Rs. comprising Rs. (v) Timing of security issues. These factors include – (i) The effect of leverage on EPS. in debt bearing an average interest of 9% and Rs.II Determinants of capital structure While deciding on an appropriate capital structure. various factors should be considered. (vi) Flexibility in future financing options.6% preference shares The number of equity shares at present is 40 lacs and the EBIT is Rs.3 cr.13 cr.5 cr. is looking at three possible financing options – (a) To issue 10 lac equity shares @ Rs. That is to say. (iv) Effect on credit / security ratings. (i) Effect of leverage on EPS • One method of examining the effect of leverage is to analyse the relationship between EBIT and EPS.5 cr. Illustration Company A with long term capitalization of Rs. You may ignore dividend distribution tax and advise the company on the best option. Assume corporate tax rate to be 40%. • EBIT – EPS analysis focuses on the EBIT indifference between financing methods with respect to EPS. .18 cr. the EBIT – EPS indifference point is the level of EBIT where EPS will be the same for two (or more) alternative methods of financing. The co. (vii) Pecking order of financing. (ii) Cash flow ability to service debts. (iii) Effect on debt ratios.50 per share (b) To avail loan @ 8% interest (c) To issue 7. for funding expansion plans.

00 Interest on existing debt 0.89 2.42 1. an indifference chart is constructed.4 cr. If we assume EBIT to be Rs. 0. . Break Even or Indifference Analysis  Based on the above table.13 Pref. Answer: The first step for analysis is to determine EBIT break-even or indifference point between various financing alternatives.38 Note: It can be observed that the EPS is higher under the debt alternative than under the preference share option despite the fact that the interest rate on debt is higher than the preference stock dividend rate.  In the chart.40 -__ PBT 3.15 3.00 4.26 1. EBIT is plotted on the horizontal axis and EPS on the vertical axis.13 1.42_ PAT 2.45 Interest on new debt .73 4.38_ Earnings available to Equity shareholders 2.26 4.55 Tax 1. For this purpose. .45 0. dividend . EPS under the three financing alternatives will be as per the following table: Equity option Debt option Pref.  For each financing alternative. 0.13 1. of shares (in lacs) 50 40 40 EPS (in rupees) 4..89 1.45 0. EPS is calculated at an assumed EBIT level.75 No. a straight line is drawn to reflect EPS for all possible levels of EBIT.55 3.00 4. The reason is interest is tax deductible while dividend is not. capital option ( Rupees in crore) Assumed EBIT 4.

EPS = 0.e.e.26/-.4. EPS = Rs.63 cr..38 cr.38. Hence.45 lacs to cover interest on existing debt.0. EPS = Rs. . interest on existing debt plus new interest) where EPS will be zero. two points are required.4. The first point is the assumed level of EBIT and the second point is the EBIT necessary to simply cover all fixed financial costs for a particular financial plan. Rs. (ii) When EBIT is Rs.. At this level. For drawing a straight line.  For the equity shares alternative: (i) EBIT required is Rs..1.4 cr.  Similarly for the debt alternative: (i) EBIT required is Rs../ (1-0.4) which works out to Rs.4 cr.. interest on existing debt plus the preference dividend) is Rs.85 lacs to cover fixed charges (i. in pre-tax terms. earnings available to equity shareholders is nil and hence EPS = 0.0. the earnings required to cover preference dividend payout will be Preference dividend / (1-T) i. EPS = Rs.. (ii) When EBIT is Rs.4. (ii) When EBIT is Rs.73/-  For the preferred stock alternative: (i) Dividend on preference shares is out of post tax profit. At this level.08 cr.e. Thus the EBIT required to cover the fixed costs (i.4 cr.

EBIT – EPS Indifference chart for the three financing alternatives 5 4 .

equity option will provide higher EPS and above the point. EPS will be higher for the debt alternative.3.2.. EBIT – C1 = EBIT – C2 S1 S2 Where . is the indifference point between debt and equity financing options where EPS is the same. S1 & S2 are the number of equity shares after the financing decision under the two alternatives  EBIT – 0. Findings  EBIT of Rs. EBIT is the EBIT at the indifference point C1 & C2 are the annual interest expenses & preferred stock dividend on pre-tax terms as applicable for the financial alternatives.45 = EBIT – 0.62 cr. equity option is preferred as EPS is higher and vice versa. If EBIT is below this point.5 0. Note: There is no indifference point between debt and preference share options.85 (EBIT indifference between equity & 0.  The indifference point between preference and equity share alternatives is at the EBIT level of Rs. Mathematical formulation of Indifference Point i.3.4 debt alternatives) . The debt alternative dominates (is higher) for all levels of EBIT by a constant EPS amount of Rs.0.e.35.45 cr. If EBIT is below Rs.62 cr.

debt alternative is too risky. Utility of EBIT – EPS analysis  EBIT – EPS analysis reveals the impact of different financing alternatives on EPS. debt alternative is too risky.  Using the indifference point between two financing alternatives. • If the objective is to maximize the EPS. To sum up.. In other words. equity financing is preferable. lower the level of EBIT in relation to the indifference point. variability of earnings). debt option is preferable. The risk attached to the use of leverage is referred to as ‘financial risk’. Summary of the effect of leverage on EPS • EPS is one of the most widely used measures of a company’s performance. .  Conversely.e. However. the decision will be to have the highest level of debt. financial leverage highlights the risk-return trade off that governs valuation. the major shortcoming is that it ignores risk (i.  Higher the level of EBIT in relation to the indifference point.  When the current EBIT is slightly above the indifference point and where the probability of earnings falling below the indifference point is high. the greater the level of EBIT and lower the probability of downside fluctuation in earnings. Thus financial leverage highlights the underlying business risk of the firm in relation to EPS. stronger is the case for the debt option. In the opposite scenario. existing and expected levels of EBIT can be easily compared.

financial risk can be totally avoided. it may result in default and ultimately insolvency. In the case of other modes of financing like leasing and preference share options.  The greater the quantum of debt with short-term maturities.  Where a company is unable to meet the fixed charges (with the exception of preference dividends). the fixed charges will be lease payments and preference dividends respectively. Hence. the use of debt should be to the extent that the perceived risk does not exceed the benefit of increased EPS. .  The fixed charges will include principal and interest payments on debt. the higher is the fixed charges for the company. by not employing any debt. the shareholders will be deprived of increased earnings. II Cash flow ability to service debt  The optimum debt-equity mix depends on the company’s ability to service debt without any threat of insolvency and operating flexibility. • Conversely. • Therefore. • Firms having stability and growth in sales and profits have stable EPS and can employ higher degree of leverage and they do not face difficulty in meeting their fixed commitments. It is therefore prudent to also analyze the cash flow ability of the firm to service fixed charges while considering an appropriate capital structure. companies with declining sales / profits should guard against the use of debt as they may face cash flow constraint in meeting their fixed obligations. However. • Financial risk is attached with the use of debt due to variability in earnings and the threat of default for non-payment of fixed charges.

interest coverage ratio is 4 times (i. This would suggest that even if EBIT drops by 75%. the greater the debt capacity. A coverage ratio of just one only would indicate that the earnings are barely sufficient to satisfy the interest payments.  The coverage ratios include – (i) Interest Coverage Ratio (ICR) • The most widely used coverage ratio to gauge the ability of a company to service the cost of debt is the interest coverage ratio. 6/1. ICR = EBIT / Interest charges on debt • Interest Coverage Ratio serves as a measure of the firm’s ability to meet its interest obligations.  Coverage ratios relate the financial charges of a firm to its ability to service them. The higher and more stable the expected future cash flows of a company.1.  To gauge the debt capacity of a company.6 cr.. during a financial year and the interest payments on all debt obligations were Rs.e. coverage ratios are worked out.5).5 cr. Rating agencies extensively use these ratios to rate instruments. • This ratio is simply the ratio of EBIT for a particular reporting period to the amount of interest charges for the period. the company would still be able to cover its interest payments out of its earnings.  Debt capacity is the maximum amount of debt that a firm can adequately service. .. Example: If a company has an EBIT of Rs.

In a highly stable business and the firm’s performance is consistent. in a highly cyclical business or where the performance of the firm has not been consistent. (ii) Debt Service Coverage Ratio (DSCR) • The interest coverage ratio indicates the ability of a company to service only the interest cost. they are calculated in pre-tax DSCR terms to be consistent with EBIT in the above equation. a relatively low interest coverage ratio may be acceptable. Hence. In the previous example. a broader analysis would include evaluation of the firm’s ability to meet the principal repayments on debts also. In other words. if principal repayment was Rs. • The inability to meet the principal repayment also constitutes default. • In general. As principal repayments are not tax deductible. However. DSCR is computed for gauging the full debt-service ability.1 cr. DSCR = 1. the interest coverage ratio in the range of 3 to 4 is widely considered as a comfortable position.• Generalizations on what an appropriate interest coverage ratio are difficult unless reference is made to the type of business in which a firm is engaged.89 as given below: DSCR . per annum and the tax rate is 40%. a lower interest coverage ratio may not be appropriate.

Any investment beyond this level can contribute to growth.89). Hence. Cash flow adequacy . earnings would still be sufficient to service the debt (both interest and principal). A DSCR closer to 1 signifies that the risk is higher as the ability to pay both interest and principal may get affected if there is a fall in the earnings. (iii) Cash flow coverage ratios Some analysts consider cash flows instead of operating earnings in working out the coverage ratios.e. a measure reflecting the amount required to cover certain expenditure necessary to keep the business operating being utilized for repayment of a debt is not a good measure for assessing the debt servicing ability.89/1. 0..The above situation would mean that even if EBIT falls by 47% (i. its impact on cash flows is exactly the same as the payment of interest and principal on debt obligations except that there is no distinction between interest and principal and the entire lease rental is revenue in nature. Note: While lease financing is not debt per se. Note: It is implicit that the amount equal to the tax benefit on depreciation is invested to maintain the earnings for the company (without any growth). These cash flow coverage ratios are computed for interest as well as for interest and principal repayments.

• For determining the company’s debt policy. Donaldson Approach (Gordon Donaldson – Corporate Debt Capacity. • Given the probabilities of particular cash flow sequences. in keeping with the spirit of his proposal. the quantum of debt that the company can take on without running out of cash to meet the interest charges and principal repayment is determined. CBr is determined. 1961) • To assess the cash adequacy. . a company should evaluate its cash flows under adverse circumstances. These conditions may or may not be the most adverse. the probability distribution of cash balances during the recession i. • Donaldson defines the net cash balance in a recession as follows: CBr = CBo + NCFr Where CBo = Cash balance at the start of recession NCFr = the net cash flow during recession By combining the cash balance at the beginning with the probability distribution of recession cash flows. Donaldson advocates examining cash flows under recessionary conditions. • The period over which cash flows are analyzed should cover various phases mainly adverse.e. not only the expected earnings are considered but also cash flows from purchase / sale of assets. • In the analysis. • Cash budgets with an element of probability for a range of possible outcomes will aid the cash flow analysis. cash flows may be analyzed over a longer time period. However..

debt capacity (i.• Based on the above. (ii) Determine for each additional debt. the likelihood of being out of cash based on the probability distribution of cash balances during recession. Note: In case of cash inadequacy (i. debt can be incurred.. The available alternatives may range from sale of investments to fixed assets. = probability distribution of CB after Rs. lack of cash after all necessary expenditure).20 cr. (iii) To set tolerance limits for the probability of being out of cash.3 cr.. CBr (-) Rs. the quantum of debt which can be serviced comfortably) is ascertained in the following manner: (i) Calculate fixed charges associated with incremental debt.e. if a company is considering a 15% debt for Rs.. the company needs to take stock of its resources. . For example.e. If the probability of being out of cash with incremental debt is negligible. which can be utilised to meet the cash flow requirements. the annual fixed charges work out to Rs. III Effect on debt ratios • Debt ratios indicate the extent to which the firm is financed by debt.3 cr.20 cr. debt.

ability to meet long term obligations). the incremental debt is simply added to the existing debts and the combined amount is taken for calculation of the debt ratios.Van Horne • Debt Ratios: To aid in the analysis of long-term liquidity of a company (i. the company needs to justify its position if its capital structure is noticeably out of line in either direction . As already indicated.• In the case of any proposed debt alternative. Note: As investment analysts and creditors tend to evaluate companies by the industry. • The revised debt ratio needs to be compared with (i) past ratios in a trend analysis (ii) the industry average.. debt ratios reflect the relative proportion of debt funds employed by a company in its business. • The comparison will bring out if the company’s proposed capital structure is significantly out of line with that of similar companies in the market place. (i) Debt Equity Ratio (Generally referred to as Long-term debt to networth ratio) . several debt ratios are computed and analyzed. the company can face any of the following two situations: (i) Cost of capital going up as risk perception changes (or) (ii) Justify the higher debt equity ratio as not being riskier in case companies in the industry are too conservative. debt is much higher. • Where in the proposed capital structure.e.

a basic utility company like Power Company has stable cash flows and hence can have a higher debt equity ratio than a machine tool company whose cash flows are far less stable. However. this has not been advocated by James C Van Horne. Debt equity ratio = Long term debt / shareholders’ funds Note: As this is not a relatively a conservative ratio. this ratio is generally adopted in practice. • Security ratings serve as a measure of the default risk of a borrower. • The rating agency evaluates and rates specific debt instruments like debentures. deposits. commercial papers etc. Long term debt / capital employed . .Capital employed includes networth plus long-term debts Note: Debt ratios vary according to the nature of business and volatility of cash flows. the effect of a financing alternative on its security rating needs to be considered. (ii) Debt Equity Ratio (as is defined by various authors and computed by analysts) Debt equity ratio = Total debt / Net worth Note: Total debt will include short term liabilities (iii) Long term debt to total capitalization Formula . For example. IV Effect on credit rating • While deciding the capital structure.

. • Frequently. . profitability ratios. raising funds through issuance of equity shares first and later with a debt issue or vice versa. • The ratings are given at the time of issuance of specific instruments and are updated throughout the life of the instrument. present and likely future capital requirements and the most important of all. it is difficult for a company to maintain strict proportions of debt / equity in its capital structure. V Timing Security Issues • The question of how to time an issue appropriately is as important as the decision to raise funds through debt or equity. the decision to take on an additional debt needs re-examination. • The cost of the debt depends on the rating. • Where an additional debt lowers a company’s security rating from an ‘investment grade’ to a ‘speculative grade’ category. • It is therefore necessary to consider the effect on the rating while determining an appropriate capital structure. the cash flow ability to service both interest and principal payments. the company’s business risk perception in the past and the expected risk profile. • In view of financing being composite (combination of multiple sources). a decision needs to be taken on the order of financing i.e. • A decision on the alternative methods of financing based on timing is mainly due to the general market conditions and the company’s forecast of the future market scenario. • Grades are assigned by rating agencies taking into consideration a number of factors such as trends in coverage & liquidity ratios.

not only can it raise funds without undue delay and cost whenever opportunities arise for profitable investments but can also substitute one form of financing with another depending on the future conditions. • To preserve flexibility in tapping capital markets. This decision is based on management’s best estimate of the future. excess resources at the company’s disposal. i.e. VI Flexibility of future financing plans • Flexibility means that the current financing decision will keep future financing options open for a company..e. (i) Loan covenants i. it is better to have unused debt capacity to meet any sudden and unpredictable fund requirements..• Where future is uncertain. • Financial flexibility depends predominantly on two factors viz. . • It is admitted that a company cannot raise funds through debt continuously without building its equity base. Where a company takes on substantial debt and things take a turn for the worse. The sequence would be timed to take advantage of the known future changes in the financial market. option for early retirement of loans with less or no penalty and (ii) The financial slack. • Thus financial flexibility means a company’s ability to adapt its capital structure to the changing conditions. • Where a company has the financial flexibility. the optimal financing sequence over a medium term may be determined.. it may be forced to issue shares on unfavourable terms in the future.

Note: Basically. Lesser floatation costs ii. financial flexibility depends a lot on the company’s unused debt capacity. Reason - i. Financial slack includes unused debt capacity such as unutilized lines of credit. Higher the debt capacity and larger the unutilized portion. the order in which different sources are desired to be tapped would be as follows: (i) Internal financing of investment opportunities – Reason - (a) To avoid outside scrutiny by suppliers of capital (b) Absence of floatation costs for retained earnings (ii) Straight debt is generally the second preference. Conclusion . excess liquid assets and also other untapped resources. (v) Finally the equity option . VII Behavioral aspect of capital structure planning • The behavioral explanation of why certain companies finance the way they do is based on a preference order which is technically referred to as ‘pecking order’ of financing. greater will be the degree of financial flexibility. (iv) Hybrid securities like convertible bonds. (iii) Next in preference is the preference shares option as it has certain features of debt. Debt is beneficial for equity shareholders as it brings down the cost of capital. Reason - (a) Investors are generally intrusive (b) Relatively costlier when compared to the other modes & (c) Higher floatation costs. • Usually.

. James C Van Horne strongly advocates that financing decisions should be based on rigorous analysis embracing valuation. In other words. capital structuring planning should generally be made keeping in view the interests of the equity shareholders.Despite the pecking order hypothesis.