CORPORATE FINANCE

CAPITAL STRUCTURE - INTRODUCTION

CMA Ramesh Rajagopalan

MBA Department
CORPORATE FINANCE

Unit-3- 1st Video

CMA Ramesh Rajagopalan

Department of Management Studies-MBA
CAPITAL STRUCTURE
Introduction

Financial Structure and Capital Structure

Capital Structure
Meaning
Concept
Optimum Capital structure
Principles
CAPITAL STRUCTURE
Introduction
Financial structure refers to the way the firm’s assets are financed with. It refers to the entire
capital and liabilities side of the balance sheet. Thus, it encompasses all sources of financing
that covers current liabilities, long-term debt, preferred stock, and common equity. The
financial structure of a firm in equation form can be written as follows:

Financial structure = Current liabilities + Long-term debt + Preferred stock + Common equity

Capital structure = Long-term debt + Preferred stock + Common equity

Note: Capital structure does not include short term liabilities or current liabilities

The relationship between financial and capital structure can be expressed as follows:

Financial structure = Current liabilities + Capital Structure OR Capital structure = Financial

structure - Current liabilities

Key Concept:

 Financial structure refers to the composition of all sources of financing.

 Capital structure refers to only the long-term sources of financing.
 Capital structure is only the part of financial structure.
CAPITAL STRUCTURE
Introduction
Capital Structure – Meaning:

 Capital structure is the combination of two words: Capital & Structure.

 The term capital refers to the funds raised from long-term sources of financing that covers
long-term debt, preferred stock, and common equity. Primarily, the total capital employed in
the firm is divided into components as debt capital and equity capital.

 On the other hand, structure refers to the composition or mix. Thus, the structure
represents the parts or proportion of each component in total.

After defining the two words capital and structure separately, we can define the capital
structure as the combination of long-term sources of fund used in the business. It represents
a proportionate mix of various long-term sources of financing. The long-term sources of
financing include long-term debt, preferred stock and common equity including retained
earnings.

In equation form, a capital structure can be shown as follows:

Capital Structure = Long-term debt + Preferred stock + Common equity

CAPITAL STRUCTURE
Introduction
Sources of Capital/Funds:
Domestic International
Equity Shares
Preference Shares
In 1993, Indian govt. permitted Indian companies to
Retained Earnings mobilize capital from foreign markets through:
Long-term loans from DFIs and Banks – Refer
notes
Foreign Currency Convertible Bonds (FCCBs) – Refer
Debentures
notes
Public Deposits Depository Participants (DPs) – Refer notes
CAPITAL STRUCTURE
Introduction
Optimal Capital Structure: Capital structure is said to be optimal, when the marginal real
cost (explicit + implicit) of each available source of financing is identical.

With an optimum Debt and Equity mix, the cost of capital is minimum and the market price
per share (total value of the firm) is maximum

Minimizing the weighted average cost of capital (WACC) is one way to optimize for the lowest
cost mix of financing.
CAPITAL STRUCTURE
Introduction
CAPITAL STRUCTURE
Introduction
Principles:
Finance manager has to decide the right combination of capital based on certain principles
and available source of funds to maximize returns. Guiding principles of capital structure are
as follows −
i. Profitability principle
ii. Solvency principle
iii. Flexibility principle
iv. Control principle
v. Conservatism principle

Profitability principle:
 Main concern of this principle is to earn maximum Earnings per share with minimum
cost of financing.
 Interest rates and tax rates controls cost of financing.
 Debt capital is cheaper.

Solvency principle:
 Main concern of this principle is that it will not accept stiff risks
 High rates on debts than earnings may lead liquidity trap
 Declaration of dividends is voluntary
 Encourages equity and limits debt as a source of funds
CAPITAL STRUCTURE
Introduction
Flexibility principle:
 Main concern of this principle is to have extra funds for future needs
 Management has to use their sources effectively for long term funds (if needed).

Control principle:
 Main concern of this principle is to issue preferred shares to keep control with
owners. (E.g. Restricted voting rights of Preference share holders)
 Maintains balance between equity and debt

Conservatism principle:
 A company that pays for assets with more equity than debt has a low leverage ratio
and a conservative capital structure.
 Conservative capital structure can lead to lower growth rates
THANK YOU

CMA Ramesh Rajagopalan

MBA Department
rameshrajagopalan@pes.edu
CORPORATE FINANCE

CAPITAL STRUCTURE – FACTORS

DETERMINING CAPITAL STRUCTURE
CMA Ramesh Rajagopalan
MBA Department
CORPORATE FINANCE

Unit-3- 2nd Video

CMA Ramesh Rajagopalan

Department of Management Studies-MBA
CAPITAL STRUCTURE
Factors determining Capital Structure
Factors influencing Capital Structure decisions:
i. Profitability aspect
ii. Growth and Stability
iii. Legal requirement
iv. Purpose of Financing
v. Period of Financing
vi. Market conditions
vii. Nature and size of firm
viii. Requirement of Investors
ix. Provision for future
x. Government policy
xi. Capital Market condition
xii. Retaining Control
CAPITAL STRUCTURE
Factors determining Capital Structure
Factors influencing Capital Structure decisions:

i. Profitability aspect:
 Primary objective of financial management is maximizing the market value of the
firm.
 EBIT-EPS analysis helps in designing the capital structure
 EBIT-EPS analysis shows the impact on EPS at various levels of EBIT
 EPS is a measure of firms performance. P/E ratio (MPS/EPS) indicates the relation
between EPS and value of firms share. (Refer Notes)

II. Growth and Stability of Sales

 Growth and stability in sales highly influence the capital structure of the company
 If the sales are expected to remain fairly stable, company can raise a higher level
of debt Stability of sales ensures that the firm will not face any difficulty in
meeting its fixed commitments of interest payment and repayments of debts
 If sales are highly fluctuating, company should not employ debt financing in its
capitals structure. (E.g. Inconsistent cash inflow will impact servicing Interest cost)
CAPITAL STRUCTURE
Factors determining Capital Structure
Factors influencing Capital Structure decisions:

(iii) Legal requirement:

 Companies have to follow statutory requirements (Ref. Notes)
 Laws or regulations preventing takeovers, M&A
 Clearance/ Approvals from regulatory bodies like RBI, SEBI, FEMA etc. (Ref. Notes)
 Banking companies are prohibited by banking regulation act from issuing any
securities except Equity shares

(iv) Purpose of Financing:

 If funds are required for the productive purpose, debt financing including
preference share capital is suitable as interest/dividend can be paid out of profits
generated from the investment. (E.g. Expansion of current capacity)
 On the contrary if the funds are required for non productive purposes with no
immediate returns, then Equity capital is more suitable (E.g. Investment on
creating & developing Training Centre for Employee skilling/up-skilling/cross
skilling)

(v) Period of Financing:

 If there is requirement of finances for shorter period, issuing debenture is best.
 If company requires funds for longer period, then issuing equity share is more
appropriate.
CAPITAL STRUCTURE
Factors determining Capital Structure
Factors influencing Capital Structure decisions:

(vi) Product/Service Market conditions :

 Demand for the product/service manufactured/provided by the company
 High demand for product/service will generate consistence cash inflow. Debt is
preferred.
 Low demand for product/service generates less & inconsistence cash inflow. Equity
capital is preferred

(vii) Nature and Size of Firm:

 Nature and size of firm also influences the capital structure.
 A public utility concern has different capital structure as compared to
manufacturing concern.
 Public utility concern may employ more of debt because of stability and regularity
of their earnings. (E.g. Railways, Post & Telegraph)
 Small companies have to depend upon owned capital, as it is very difficult for them
to raise long term loans on reasonable terms
CAPITAL STRUCTURE
Factors determining Capital Structure
Factors influencing Capital Structure decisions:

(viii) Requirement of Investors:

 It is necessary to meet the requirement of both institutional as well as private
investors in case of debt financing.
 Investors who are over cautious (Risk averse) prefer safety of investment and
regular income, so debentures would satisfy such investors.
 Investors, who are less cautious (More Aggressive) and needs capital appreciation
will prefer preference share capital.

(ix) Provision for future:

 Appropriation of adequate amount from net profit to Retained Earnings
 Equitable appropriation of net profit between dividends and retained earnings

(x) Government Policy:

 Banking companies can raise funds only through share capital and no other
securities
 Maintain minimum Debt Equity ratio standards (E.g. Usually 1.5 : 1 or less is
preferred)
CAPITAL STRUCTURE
Factors determining Capital Structure
Factors influencing Capital Structure decisions:

(xi) Capital Market conditions :

 Market conditions also influence the choice of securities
 If share market is going down the company should not issue equity share capital
as investors would prefer safety
 In case of boom period, it would be advisable to issue equity share capital

(xii) Retaining Control

 Whenever additional funds are required, the management of the firm wants to
raise the funds without any loss of control over the firm.
 In case funds are raised through issue of equity shares, the control of
existing shares are diluted
 Preference shareholders and debenture holders do not have the voting right. From
the point of view of control, debt financing is recommended.

(xiii) Floatation Cost:

 The cost of financing a debt is generally less than the cost of floating equity and
hence it may persuade the management to raise debt financing
 Usually, debt is cheaper source of finance compared to preference and equity.
Preference capital is cheaper than equity because of lesser risk involved
CAPITAL STRUCTURE
Factors determining Capital Structure

Appendix
THANK YOU

CMA Ramesh Rajagopalan

MBA Department
rameshrajagopalan@pes.edu
CORPORATE FINANCE

CAPITAL STRUCTURE – FACTORS DETERMINING

CAPITAL STRUCTURE – CALCULATION OF EPS

CMA Ramesh Rajagopalan

MBA Department
CORPORATE FINANCE

Unit-3- 3rd Video

CMA Ramesh Rajagopalan

Department of Management Studies-MBA
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS

Calculation of EPS
What is EPS?
Basic format for calculating EPS
Formula and Example
Significance and Limitations
Illustrations
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS
What is EPS?

Earnings per Share (EPS) means how much money a company makes for each
share and is primarily used for estimating corporate value. Increasing EPS implies
the company is becoming more profitable and vice versa.

EPS Formula:

EPS = [ Net Income – Preferred Dividends ] / Common Shares Outstanding

Example – A company, ABC, reports a net income of Rs.12Lakhs and announces

Rs.2Lakhs in preferred dividends for its fiscal Q1. During the period, the company
had 5Lakhs (weighted average) outstanding shares.

The EPS of the ABC company as per the formula mentioned above would be
EPS = Rs. (12Lakhs – Rs.2Lakhs) / 5Lakhs = Rs.2

Note: It is advisable to use a weighted average number of outstanding common

stock over the reporting term as the actual number of shares can vary over time.
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS
Basic format for calculating EPS

Details Rs.

Earnings Before Interest and Taxes (EBIT) 10,00,000

Less: Interest 1,00,000

Earnings after Interest but before Taxes (EBT) 9,00,000

Less: Taxes (50%) 4,50,000

Earnings after Interest and Taxes (EAT) 4,50,000

Less: Preference Dividend 50,000

Earnings Available to Equity shareholders 4,00,000

(÷) Number of Outstanding Equity shares 1,00,000

Earnings per share (EPS) = Earnings Available to Equity shareholders /

4.00
Number of Outstanding Equity shares
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS
EPS Formula:

(EBIT-I) x (1-T) – PD
EPS = -------------------------------------
N

Where,

EBIT - Earnings before Interest and Taxes

I - Amount of Interest
T - Tax Rate
PD - Preference Dividend
N - Number of outstanding Equity shares

Note: Net Income = (EBIT-I) x (1-T) – PD

CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS

Example using the table in the previous slide:

(Rs.10,00,000 – Rs.1,00,000) x (1 – 0.50) – Rs.50,000

EPS = --------------------------------------------------------
1,00,000

(Rs. 9,00,000) x (0.50) – Rs.50,000

EPS = -------------------------------------------------------
1,00,000

Rs.4,50,000 – Rs.50,000 Rs.4,00,000

EPS = ------------------------------------ = ------------------ = Rs. 4.00
1,00,000 1,00,000
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS
Significance of Earnings Per Share:
 EPS helps investors understand whether investing in a particular company is profitable. A consistent
EPS growth may indicate the company’s profitability, suggesting its ability to pay higher dividends over
time.

 EPS is an input in the P/E ratio (i.e. the E in P/E is EPS, that can help you compare the performance of
promising companies and select the most suitable option).

 Earnings per share can help you understand the company’s present financial standing and track its
historical performance. For example, a company with a consistently rising EPS is often considered a safe
investment option. Similarly, companies with declining or irregular EPS are typically not preferred by
regular investors.

Some Limitations of Earnings Per Share:

 Companies may manipulate EPS through stock buyback etc to show profitability. While most of these
attempts are short-term, it may hamper the company’s reputation and profitability in the long-term.

 EPS does not account for the debt that the company holds. It thus gives only a partial picture of the
company’s financial position. (E.g. Appropriation of Net Profit is not considered)

 EPS calculation also doesn’t factor in cash flow, which is a critical aspect for gauging a company’s debt
repaying ability. Hence, EPS might prove ineffective for evaluating the company’s solvency.
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS

Note: LTB stands for Long Term Borrowing

CAPITAL STRUCTURE
Factors determining Capital Structure – Calculation of EPS

Appendix
THANK YOU

CMA Ramesh Rajagopalan

MBA Department
rameshrajagopalan@pes.edu
CORPORATE FINANCE

CAPITAL STRUCTURE – FACTORS DETERMINING

CAPITAL STRUCTURE-CALCULATION OF EPS

CMA Ramesh Rajagopalan

MBA Department
CORPORATE FINANCE

Unit-3- 4th Video

CMA Ramesh Rajagopalan

Department of Management Studies-MBA
CAPITAL STRUCTURE
Factors determining Capital Structure-Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure-Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure-Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure-Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure-Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure-Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure-Calculation of EPS
CAPITAL STRUCTURE
Factors determining Capital Structure

Appendix
THANK YOU

CMA Ramesh Rajagopalan

MBA Department
rameshrajagopalan@pes.edu