Financial Management

Capital Structure
 ►Definition of Capital Structure:
Capital Structure refers the existing capital structure of a firm, which
combines with debt-equity and others elements.

►Elements of capital structure :

a) Equity Share
b) Debenture
c) Preference Share
d) Retained Earnings
• Optimum or Optimal Capital Structure:
• The combination of debt-equity, which ensures highest value of firm
with lowest cost of capital.
P#1:
The capital structure of Zee Ltd. are –
Equity capital (@tk. 100) = Tk. 3, 00,000
10% debt = 2, 00,000
Tk. 5, 00, 000
They need tk. 150,000 for development program and has three options:
Op – 1: - Can issue equity share @ tk. 100
Op – 2: - Can issue 10% debt.
Op – 3: - 60% from equity financing and 40% from 10% debt.
Which option should they choose if EBIT is tk. 200,000 and tax rate is 40%?
Solution:
Working: - 1
Calculation of number of equity share
Old New Total
Op – 1: - 3,000 1,500 4,500
Op – 2: - 3,000 Nil 3,000
Op – 3: - 3,000 900 3,900

Working: - 2
Calculation of interest on debt
Old New Total
Op – 1: - 20,000 Nill 20,000
Op – 2: - 20,000 15,000 35,000
Op – 3: - 20,000 6,000 26,000
 Calculation on EPS
Op – 1 Op – 2 Op – 3
EBIT 200,000 200,000 200,000

(-) Interest on debt 20,000 35,000 26,000

EBT 180,000 165,000 174,000

(-) Tax 40% 72,000 66,000 69,900

EAT 108,000 99,000 104,100

EAT 108 ,000 99,000 104 ,100

∴ EPS = =
No .of equity shareholders 4,500 3,000 3,900

= Tk. 24 = Tk. 33 = Tk. 26.77

Decision:
They should choose op-2 i,e 10% debt, because it shows highest EPS.
P#2:
The capital structure of Zex Ltd. are –
Equity capital (@tk. 100) = Tk. 4, 00,000
10% debt = 3, 00,000
Tk. 7, 00, 000
The firm need tk. 200,000 for expansion program and have three options:
Op – 1: - Can issue equity share @ tk. 100 each.
Op – 2: - Can issue 10% debt.
Op – 3: - 50% from equity financing and 50% from 10% debt.
Requirement:
a) Which option should they choose if EBIT is tk. 150,000 and tax rate is 40%?
b) Find out the indifference point EBIT between op-1 and op-2 and verify your
answer.
c) Graphically show the financial plan of the firm.
Solution:
Req. – (a)
Working: - 1
Calculation of number of equity share
Old New Total
Op – 1: - 4,000 2,000 6,000
Op – 2: - 4,000 Nill 4,000
Op – 3: - 4,000 1,000 5,000

Working: - 2
Calculation of interest on debt
Old New Total
Op – 1: - 30,000 Nill 30,000
Op – 2: - 30,000 20,000 50,000
Op – 3: - 30,000 10,000 40,000
 Calculation on EPS
Op – 1 Op – 2 Op – 3
EBIT 150,000 150,000 150,000

(-) Interest on debt 30,000 50,000 40,000

EBT 120,000 100,000 110,000

(-) Tax 40% 48,000 40,000 44,000

EAT 72,000 60,000 66,000

EAT 72,000 60,000 66,000

∴ EPS = =
No .of equity shareholders 6,000 4,000 5,000

= Tk. 12 = Tk. 15 = Tk. 13.20

Decision:
They should choose op-2 i,e 10% debt, because it shows highest EPS.
 Req. – (b)
Indifference point of EBIT:
We know,
ሺEBIT −I1 ሻ(1 − 𝑡) ሺEBIT −I2 ሻ(1 − 𝑡)
=
N1 N2
Here,
I1 = Interest in op-1
I2 = Interest in op-2
N1 = No. of Equity Share op-1
N2 = No. of Equity Share op-2
t = tax rate
Now,
ሺ
EBIT −I1 ሻ(1 − 𝑡) ሺ
EBIT −I2 ሻ(1 − 𝑡)
=
N1 N2

ሺ
EBIT − 30,000 ሻ(1 −0.40) ሺ
EBIT − 50,000 ሻ(1 − 0.40)
 =
6,000 4,000
ሺ
0.60 EBIT − 18,000 ሻ ሺ
0.60 EBIT − 30,000 ሻ
 = [Multiplied by 1,000]
6 4

 3.60 EBIT – 180,000 = 2.40 EBIT – 72,000

 3.60 EBIT – 2.40 EBIT = 180,000 – 72,000

 1.20 EBIT = 108,000

∴EBIT = Tk. 90,000

So, Identification of EBIT is tk. 90,000
Verification:
Op – 1 Op – 2
EBIT 90,000 90,000

(-) Interest on debt 30,000 50,000

EBT 60,000 40,000

(-) Tax 40% 24,000 16,000

EAT 36,000 24,000

EAT 36,000 24,000

∴ EPS = =
No .of equity shareholders 6,000 4,000

= TK. 6 = Tk. 6 (Verified)

 Req. – (c)
Graphical Presentation of Financial Plan:
Y op-2 op-1

6 Indifference Point

0
20 30 40 50 60 70 80 90 100

Interest and EBIT (in thousands)

P#3:
A firm needs tk. 1,000,000 for a project, which will create annual EBIT of tk.
160,000. Management of firm wants to take debenture of tk. 100,000 or tk.
400,000 or tk. 600,000. Current equity price in the market is tk. 100 and chance to
drop to tk. 80 if debenture amount would more than tk. 500,000.
Interest rate:
1. Up to tk. 100,000 @ 8% interest.
2. More than 100,000 up to tk. 500,000 @ 12%.
3. More than tk. 500,000 @ 18%.
Find out the optimum amount of debenture for the firm if tax rate is 40%.
Solution: Working: - 1
Calculation of Number of Equity Share
op – 1 [debt of tk. 100,000] (1,000,000 – 100,000) ÷ 100 = 9,000 shares
op – 2 [debt of tk. 400,000] (1,000,000 – 400,000) ÷ 100 = 6,000 shares
op – 3 [debt of tk. 600,000] (1,000,000 – 600,000) ÷ 80 = 5,000 shares
 Working: - 2
Calculation of Interest on Debt:
op – 1 [debt of tk. 100,000]
Tk. 100,000 @ 8% = Tk. 8000
op – 2 [debt of tk. 400,000]
Tk. 100,000 @ 8% = Tk. 8000
Next Tk. 300,000 @ 12% interest = Tk. 36,000
= Tk. 44,000
op – 3 [debt of tk. 600,000]
Tk. 100,000 @ 8% = Tk. 8000
Next Tk. 400,000 @ 12% interest = Tk. 48,000
Next Tk. 100,000 @ 18% interest = Tk. 18,000
= Tk. 74,000
Calculation of EPS:
Op – 1 Op – 2 Op – 3
EBIT 160,000 160,000 160,000

(-) Interest on debt 8,000 44,000 74,000

EBT 152,000 116,000 86,000

(-) Tax 40% 60,800 46,400 34,400

EAT 91,200 69,600 51,600

EAT 91,200 69,600 51,600

∴ EPS = =
No .of equity shareholders 9,000 6,000 5,000

= Tk. 10.13 = Tk. 11.60 = Tk. 10.32

Decision:
They should take debenture of tk. 400,000, because it shows highest EPS.