Unit- 3

Meaning and Concept of Capital Structure:

The term ‘structure’ means the arrangement of the various parts. So capital structure means the
arrangement of capital from different sources so that the long-term funds needed for the business
are raised.

Thus, capital structure refers to the proportions or combinations of equity share capital,
preference share capital, debentures, long-term loans, retained earnings and other long-term
sources of funds in the total amount of capital which a firm should raise to run its business.

Few definitions of capital structure given by some financial experts:

“Capital structure of a company refers to the make-up of its capitalisation and it includes all
long-term capital resources viz., loans, reserves, shares and bonds.”—Gerstenberg.

“Capital structure is the combination of debt and equity securities that comprise a firm’s
financing of its assets.”—John J. Hampton.

“Capital structure refers to the mix of long-term sources of funds, such as, debentures, long-term
debts, preference share capital and equity share capital including reserves and surplus.”—I. M.
Pandey.

Capital Structure, Financial Structure and Assets Structure:

The term capital structure should not be confused with Financial structure and Assets structure.
While financial structure consists of short-term debt, long-term debt and share holders’ fund i.e.,
the entire left hand side of the company’s Balance Sheet. But capital structure consists of long-
term debt and shareholders’ fund.

So, it may be concluded that the capital structure of a firm is a part of its financial structure.
Some experts of financial management include short-term debt in the composition of capital
structure. In that case, there is no difference between the two terms—capital structure and
financial structure.

So, capital structure is different from financial structure. It is a part of financial structure. Capital
structure refers to the proportion of long-term debt and equity in the total capital of a company.
On the other hand, financial structure refers to the net worth or owners’ equity and all liabilities
(long-term as well as short-term).

Capital structure does not include short-term liabilities but financial structure includes short-term
liabilities or current liabilities.

Assets structure implies the composition of total assets used by a firm i.e., make-up of the assets
side of Balance Sheet of a company. It indicates the application of fund in the different types of
assets fixed and current.

Assets structure = Fixed Assets + Current Assets.

The term capitalisation means the total amount of long-term funds at the disposal of the
company, whether raised from equity shares, preference shares, retained earnings, debentures, or
institutional loans.

Importance of Capital Structure:

The importance or significance of Capital Structure:

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and securities
which, in turn, lead to increase in the value of the firm.

2. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise the available funds fully. A
properly designed capital structure ensures the determination of the financial requirements of the
firm and raise the funds in such proportions from various sources for their best possible
utilisation. A sound capital structure protects the business enterprise from over-capitalisation and
under-capitalisation.

3. Maximisation of return:

A sound capital structure enables management to increase the profits of a company in the form of
higher return to the equity shareholders i.e., increase in earnings per share. This can be done by
the mechanism of trading on equity i.e., it refers to increase in the proportion of debt capital in
the capital structure which is the cheapest source of capital. If the rate of return on capital
employed (i.e., shareholders’ fund + long- term borrowings) exceeds the fixed rate of interest
paid to debt-holders, the company is said to be trading on equity.

4. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders’ wealth through
minimisation of the overall cost of capital. This can also be done by incorporating long-term debt
capital in the capital structure as the cost of debt capital is lower than the cost of equity or
preference share capital since the interest on debt is tax deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising of debt
capital because, at the time of poor earning, the solvency is disturbed for compulsory payment of
interest to .the debt-supplier.

6. Flexibility:

A sound capital structure provides a room for expansion or reduction of debt capital so that,
according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:

A good capital structure does not allow the equity shareholders control on business to be diluted.
8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e.,
payment of fixed interest charges and repayment of principal amount of debt in time) will also
increase. A sound capital structure protects a business enterprise from such financial risk through
a judicious mix of debt and equity in the capital structure.

Factors Determining Capital Structure:

The following factors influence the capital structure decisions:

1. Risk of cash insolvency:

Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally, the higher
proportion of debt in capital structure compels the company to pay higher rate of interest on debt
irrespective of the fact that the fund is available or not. The non-payment of interest charges and
principal amount in time call for liquidation of the company.

The sudden withdrawal of debt funds from the company can cause cash insolvency. This risk
factor has an important bearing in determining the capital structure of a company and it can be
avoided if the project is financed by issues equity share capital.

2. Risk in variation of earnings:

The higher the debt content in the capital structure of a company, the higher will be the risk of
variation in the expected earnings available to equity shareholders. If return on investment on
total capital employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest rate, the
shareholders get a higher return.

On the other hand, if interest rate exceeds return on investment, the shareholders may not get any
return at all.

3. Cost of capital:

Cost of capital means cost of raising the capital from different sources of funds. It is the price
paid for using the capital. A business enterprise should generate enough revenue to meet its cost
of capital and finance its future growth. The finance manager should consider the cost of each
source of fund while designing the capital structure of a company.

4. Control:

The consideration of retaining control of the business is an important factor in capital structure
decisions. If the existing equity shareholders do not like to dilute the control, they may prefer
debt capital to equity capital, as former has no voting rights.

5. Trading on equity:

The use of fixed interest bearing securities along with owner’s equity as sources of finance is
known as trading on equity. It is an arrangement by which the company aims at increasing the
return on equity shares by the use of fixed interest bearing securities (i.e., debenture, preference
shares etc.).
If the existing capital structure of the company consists mainly of the equity shares, the return on
equity shares can be increased by using borrowed capital. This is so because the interest paid on
debentures is a deductible expenditure for income tax assessment and the after-tax cost of
debenture becomes very low.

Any excess earnings over cost of debt will be added up to the equity shareholders. If the rate of
return on total capital employed exceeds the rate of interest on debt capital or rate of dividend on
preference share capital, the company is said to be trading on equity.

6. Government policies:

Capital structure is influenced by Government policies, rules and regulations of SEBI and
lending policies of financial institutions which change the financial pattern of the company
totally. Monetary and fiscal policies of the Government will also affect the capital structure
decisions.

7. Size of the company:

Availability of funds is greatly influenced by the size of company. A small company finds it
difficult to raise debt capital. The terms of debentures and long-term loans are less favourable to
such enterprises. Small companies have to depend more on the equity shares and retained
earnings.

On the other hand, large companies issue various types of securities despite the fact that they pay
less interest because investors consider large companies less risky.

8. Needs of the investors:

While deciding capital structure the financial conditions and psychology of different types of
investors will have to be kept in mind. For example, a poor or middle class investor may only be
able to invest in equity or preference shares which are usually of small denominations, only a
financially sound investor can afford to invest in debentures of higher denominations.

A cautious investor who wants his capital to grow will prefer equity shares.

9. Flexibility:

The capital structures of a company should be such that it can raise funds as and when required.
Flexibility provides room for expansion, both in terms of lower impact on cost and with no
significant rise in risk profile.

10. Period of finance:

The period for which finance is needed also influences the capital structure. When funds are
needed for long-term (say 10 years), it should be raised by issuing debentures or preference
shares. Funds should be raised by the issue of equity shares when it is needed permanently.

11. Nature of business:

It has great influence in the capital structure of the business, companies having stable and certain
earnings prefer debentures or preference shares and companies having no assured income
depends on internal resources.
12. Legal requirements:

The finance manager should comply with the legal provisions while designing the capital
structure of a company.

13. Purpose of financing:

Capital structure of a company is also affected by the purpose of financing. If the funds are
required for manufacturing purposes, the company may procure it from the issue of long- term
sources. When the funds are required for non-manufacturing purposes i.e., welfare facilities to
workers, like school, hospital etc. the company may procure it from internal sources.

14. Corporate taxation:

When corporate income is subject to taxes, debt financing is favourable. This is so because the
dividend payable on equity share capital and preference share capital are not deductible for tax
purposes, whereas interest paid on debt is deductible from income and reduces a firm’s tax
liabilities. The tax saving on interest charges reduces the cost of debt funds.

Moreover, a company has to pay tax on the amount distributed as dividend to the equity
shareholders. Due to this, total earnings available for both debt holders and stockholders is more
when debt capital is used in capital structure. Therefore, if the corporate tax rate is high enough,
it is prudent to raise capital by issuing debentures or taking long-term loans from financial
institutions.

15. Cash inflows:

The selection of capital structure is also affected by the capacity of the business to generate cash
inflows. It analyses solvency position and the ability of the company to meet its charges.

16. Provision for future:

The provision for future requirement of capital is also to be considered while planning the capital
structure of a company.

17. EBIT-EPS analysis:

If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the EBIT is
high from EPS point of view, debt financing is preferable to equity. If ROI is less than the
interest on debt, debt financing decreases ROE. When the ROI is more than the interest on debt,
debt financing increases ROE.

Relevance Theory and Irrelevance Theory of Capital Structure

Capital Structure Theory # 1. Net Income (NI) Approach:

According to NI approach a firm may increase the total value of the firm by lowering its cost of
capital.

When cost of capital is lowest and the value of the firm is greatest, we call it the optimum capital
structure for the firm and, at this point, the market price per share is maximised.
The same is possible continuously by lowering its cost of capital by the use of debt capital. In
other words, using more debt capital with a corresponding reduction in cost of capital, the value
of the firm will increase.

The same is possible only when:

(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);

(ii) There are no taxes; and
(iii) The use of debt does not change the risk perception of the investors since the degree of
leverage is increased to that extent.
Since the amount of debt in the capital structure increases, weighted average cost of capital
decreases which leads to increase the total value of the firm. So, the increased amount of debt
with constant amount of cost of equity and cost of debt will highlight the earnings of the
shareholders.
Illustration 1:
X Ltd. presents the following particulars:
EBIT (i.e., Net Operating income) is Rs. 30,000;
The equity capitalisation ratio (i.e., cost of equity) is 15% (Ke);
Cost of debt is 10% (Kd);
Total Capital amounted to Rs. 2,00,000.
Calculate the cost of capital and the value of the firm for each of the following alternative
leverage after applying the NI approach.
Leverage (Debt to total Capital) 0%, 20%, 50%, 70% and 100%.
From the above table it is quite clear that the value of the firm (V) will be increased if there is a
proportionate increase in debt capital but there will be a reduction in overall cost of capital. So,
Cost of Capital is increased and the value of the firm is maximum if a firm uses 100% debt
capital.

It is interesting to note the NI approach can also be graphically presented as under (with
the help of the above illustration):

The degree of leverage is plotted along the X-axis whereas K e, Kw and Kd are on the Y-axis. It
reveals that when the cheaper debt capital in the capital structure is proportionately increased, the
weighted average cost of capital, Kw, decreases and consequently the cost of debt is Kd.

Thus, it is needless to say that the optimal capital structure is the minimum cost of capital if
financial leverage is one; in other words, the maximum application of debt capital.

The value of the firm (V) will also be the maximum at this point.

Capital Structure Theory # 2. Net Operating Income (NOI) Approach:

Now we want to highlight the Net Operating Income (NOI) Approach which was advocated by
David Durand based on certain assumptions.

They are:

(i) The overall capitalisation rate of the firm Kw is constant for all degree of leverages;

(ii) Net operating income is capitalised at an overall capitalisation rate in order to have the total
market value of the firm.

Thus, the value of the firm, V, is ascertained at overall cost of capital (Kw):

V = EBIT/Kw (since both are constant and independent of leverage)

(iii) The market value of the debt is then subtracted from the total market value in order to get
the market value of equity.

S–V–T
(iv) As the Cost of Debt is constant, the cost of equity will be

Ke = EBIT – I/S

The NOI Approach can be illustrated with the help of the following diagram:

Under this approach, the most significant assumption is that the K w is constant irrespective of the
degree of leverage. The segregation of debt and equity is not important here and the market
capitalises the value of the firm as a whole.

Thus, an increase in the use of apparently cheaper debt funds is offset exactly by the
corresponding increase in the equity- capitalisation rate. So, the weighted average Cost of
Capital Kw and Kd remain unchanged for all degrees of leverage. Needless to mention here that,
as the firm increases its degree of leverage, it becomes more risky proposition and investors are
to make some sacrifice by having a low P/E ratio.

Capital Structure Theory # 3. Traditional Theory Approach:

It is accepted by all that the judicious use of debt will increase the value of the firm and reduce
the cost of capital. So, the optimum capital structure is the point at which the value of the firm is
highest and the cost of capital is at its lowest point. Practically, this approach encompasses all the
ground between the Net Income Approach and the Net Operating Income Approach, i.e., it may
be called Intermediate Approach.

The traditional approach explains that up to a certain point, debt-equity mix will cause the
market value of the firm to rise and the cost of capital to decline. But after attaining the optimum
level, any additional debt will cause to decrease the market value and to increase the cost of
capital.

In other words, after attaining the optimum level, any additional debt taken will offset the use of
cheaper debt capital since the average cost of capital will increase along with a corresponding
increase in the average cost of debt capital.

Thus, the basic proposition of this approach are:

(a) The cost of debt capital, Kd, remains constant more or less up to a certain level and thereafter
rises.

(b) The cost of equity capital Ke, remains constant more or less or rises gradually up to a certain
level and thereafter increases rapidly.

(c) The average cost of capital, K w, decreases up to a certain level remains unchanged more or
less and thereafter rises after attaining a certain level.

The traditional approach can graphically be represented under taking the data from the
previous illustration:

It is found from the above that the average cost curve is U-shaped. That is, at this stage the cost
of capital would be minimum which is expressed by the letter ‘A’ in the graph. If we draw a
perpendicular to the X-axis, the same will indicate the optimum capital structure for the firm.

Thus, the traditional position implies that the cost of capital is not independent of the capital
structure of the firm and that there is an optimal capital structure. At that optimal structure, the
marginal real cost of debt (explicit and implicit) is the same as the marginal real cost of equity in
equilibrium.

For degree of leverage before that point, the marginal real cost of debt is less than that of equity
beyond that point the marginal real cost of debt exceeds that of equity.

Illustration 3:
Calculate the cost of capital and the value of the firm under each of the following
alternative degrees of leverage and comment on them:

Thus, from the above table, it becomes quite clear the cost of capital is lowest (at 25%) and the
value of the firm is the highest (at Rs. 2,33,333) when debt-equity mix is (1,00,000 : 1,00,000 or
1: 1). Hence, optimum capital structure in this case is considered as Equity Capital (Rs. 1,00,000)
and Debt Capital (Rs. 1,00,000) which bring the lowest overall cost of capital followed by the
highest value of the firm.

Variations on the Traditional Theory:

This theory underlines between the Net Income Approach and the Net Operating Income
Approach. Thus, there are some distinct variations in this theory. Some followers of the
traditional school of thought suggest that Ke does not practically rise till some critical conditions
arise. Only after attaining that level the investors apprehend the increasing financial risk and
penalise the market price of the shares. This variation expresses that a firm can have lower cost
of capital with the initial use of leverage significantly.

This variation in Traditional Approach is depicted as:

Other followers e.g., Solomon, are of opinion the K e is being saucer-shaped along with a
horizontal middle range. It explains that optimum capital structure has a range where the cost of
capital is rather minimised and where the total value of the firm is maximised. Under the
circumstances a change in leverage has, practically, no effect on the total firm’s value. So, this
approach grants some sort of variation in the optimal capital structure for various firms under
debt-equity mix.

Such variation can be depicted in the form of graphical representation:

Capital Structure Theory # 4. Modigliani-Miller (M-M) Approach:

Modigliani-Miller’ (MM) advocated that the relationship between the cost of capital, capital
structure and the valuation of the firm should be explained by NOI (Net Operating Income
Approach) by making an attack on the Traditional Approach.

The Net Operating Income Approach, supplies proper justification for the irrelevance of the
capital structure. In Income Approach, supplies proper justification for the irrelevance of the
capital structure.

In this context, MM support the NOI approach on the principle that the cost of capital is not
dependent on the degree of leverage irrespective of the debt-equity mix. In the words, according
to their thesis, the total market value of the firm and the cost of capital are independent of the
capital structure.
They advocated that the weighted average cost of capital does not make any change with a
proportionate change in debt-equity mix in the total capital structure of the firm.

The same can be shown with the help of the following diagram:

Proposition:

The following propositions outline the MM argument about the relationship between cost
of capital, capital structure and the total value of the firm:

(i) The cost of capital and the total market value of the firm are independent of its capital
structure. The cost of capital is equal to the capitalisation rate of equity stream of operating
earnings for its class, and the market is determined by capitalising its expected return at an
appropriate rate of discount for its risk class.

(ii) The second proposition includes that the expected yield on a share is equal to the appropriate
capitalisation rate of a pure equity stream for that class, together with a premium for financial
risk equal to the difference between the pure-equity capitalisation rate (K e) and yield on debt
(Kd). In short, increased Ke is offset exactly by the use of cheaper debt.

(iii) The cut-off point for investment is always the capitalisation rate which is completely
independent and unaffected by the securities that are invested.

Assumptions:

The MM proposition is based on the following assumptions:

(a) Existence of Perfect Capital Market It includes:

(i) There is no transaction cost;

(ii) Flotation costs are neglected;

(iii) No investor can affect the market price of shares;

(iv) Information is available to all without cost;

(v) Investors are free to purchase and sale securities.

(b) Homogeneous Risk Class/Equivalent Risk Class:

It means that the expected yield/return have the identical risk factor i.e., business risk is equal
among all firms having equivalent operational condition.

(c) Homogeneous Expectation:

All the investors should have identical estimate about the future rate of earnings of each firm.

(d) The Dividend pay-out Ratio is 100%:

It means that the firm must distribute all its earnings in the form of dividend among the
shareholders/investors, and

(e) Taxes do not exist:

That is, there will be no corporate tax effect (although this was removed at a subsequent date).

Interpretation of MM Hypothesis:

The MM Hypothesis reveals that if more debt is included in the capital structure of a firm, the
same will not increase its value as the benefits of cheaper debt capital are exactly set-off by the
corresponding increase in the cost of equity, although debt capital is less expensive than the
equity capital. So, according to MM, the total value of a firm is absolutely unaffected by the
capital structure (debt-equity mix) when corporate tax is ignored.

Proof of MM Hypothesis—The Arbitrage Mechanism:

MM have suggested an arbitrage mechanism in order to prove their argument. They argued that
if two firms differ only in two points viz. (i) the process of financing, and (ii) their total market
value, the shareholders/investors will dispose-off share of the over-valued firm and will purchase
the share of under-valued firms.

Naturally, this process will be going on till both attain the same market value. As such, as soon
as the firms will reach the identical position, the average cost of capital and the value of the firm
will be equal. So, total value of the firm (V) and Average Cost of Capital, (Kw) are independent.

It can be explained with the help of the following illustration:

Let there be two firms, Firm ‘A’ and Firm ‘B’. They are similar in all respects except in the
composition of capital structure. Assume that Firm ‘A’ is financed only by equity whereas Firm
‘B’ is financed by a debt-equity mix.

The following particulars are presented:

From the table presented above, it is learnt that value of the levered firm ‘B’ is higher than the
unlevered firm ‘A’. According to MM, such situation cannot persist long as the investors will
dispose-off their holding of firm ‘B’ and purchase the equity from the firm ‘A’ with personal
leverage. This process will be continued till both the firms have same market value.

Suppose Ram, an equity shareholder, has 1% equity of firm ‘B’. He will do the following:

(i) At first, he will dispose-off his equity of firm ‘B’ for Rs. 3,333.

(ii) He will take a loan of Rs. 2,000 at 5% interest from personal account.

(iii) He will purchase by having Rs. 5,333 (i.e. Rs. 3,333 + Rs. 2,000) 1.007% of equity from the
firm ‘A’.

By this, his net income will be increased as:

Obviously, this net income of Rs. 433 is higher than that of the firm ‘B’ by disposing-off 1%
holding.

It is needless to say that when the investors will sell the shares of the firm ‘B’ and will purchase
the shares from the firm ‘A’ with personal leverage, this market value of the share of firm ‘A’
will decline and, consequently, the market value of the share of firm ‘B’ will rise and this will be
continued till both of them attain the same market value.

We know that the value of the levered firm cannot be higher than that of the unlevered firm
(other things being equal) due to that arbitrage process. We will now highlight the reverse
direction of the arbitrage process.
Consider the following illustration:

In the above circumstances, equity shareholder of the firm ‘A’ will sell his holdings and by the
proceeds he will purchase some equity from the firm ‘B’ and invest a part of the proceeds in debt
of the firm ‘B’.

For instance, an equity shareholder holding 1% equity in the firm ‘A’ will do the following:

(i) He will dispose-off his 1% equity of firm ‘A’ for Rs. 6,250.

(ii) He will buy 1 % of equity and debt of the firm ‘B’ for the like amount.

(iii) As a result, he will have an additional income of Rs. 86.

Thus, if the investors prefer such a change, the market value of the equity of the firm ‘A’ will
decline and, consequently, the market value of the shares of the firm ‘B’ will tend to rise and this
process will be continued till both the firms attain the same market value, i.e., the arbitrage
process can be said to operate in the opposite direction.

Criticisms of the MM Hypothesis:

We have seen (while discussing MM Hypothesis) that MM Hypothesis is based on some

assumptions. There are some authorities who do not recognise such assumptions as they are quite
unrealistic, viz. the assumption of perfect capital market.

We also know that most significant element in this approach is the arbitrage process forming the
behavioural foundation of the MM Hypothesis. As the imperfect market exists, the arbitrage
process will be of no use and as such, the discrepancy will arise between the market value of the
unlevered and levered firms.

The shortcomings for which arbitrage process fails to bring the equilibrium condition are:

(i) Existence of Transaction Cost:

The arbitrage process is affected by the transaction cost. While buying securities, this cost is
involved in the form of brokerage or commission etc. for which extra amount is to be paid which
increases the cost price of the shares and requires a greater amount although the return is same.
As such, the levered firm will enjoy a higher market value than the unlevered firm.

(ii) Assumption of borrowing and lending by the firms and the individual at the same rate
of interest:
The above proposition that the firms and the individuals can borrow or lend at the same rate of
interest, does not hold good in reality. Since a firm holds more assets and credit reputation in the
open market in comparison with an individual, the former will always enjoy a better position
than the latter.

As such, cost of borrowing will be higher in case of an individual than a firm. As a result, the
market value of both the firms will not be equal.

(iii) Institutional Restriction:

The arbitrage process is retarded by the institutional investors e.g., Life Insurance Corporation of
India, Commercial Banks; Unit Trust of India etc., i.e., they do not encourage personal leverage.
At present these institutional investors dominate the capital market.

(iv) “Personal or home-made leverage” is not the prefect substitute for “corporate
leverage.”:

MM hypothesis assumes that “personal leverage” is a perfect substitute for “corporate leverage”
which is not true as we know that a firm may have a limited liability whereas there is unlimited
liability in case of individuals. For this purpose, both of them have different footing in the capital
market.

(v) Incorporation of Corporate Taxes:

If corporate taxes are considered (which should be taken into consideration) the MM approach
will be unable to discuss the relationship between the value of the firm and the financing
decision. For example, we know that interest charges are deducted from profit available for
dividend, i.e., it is tax deductible.

In other words, the cost of borrowing funds is comparatively less than the contractual rate of
interest which allows the firm regarding tax advantage. Ultimately, the benefit is being enjoyed
by the equity-holders and debt-holders.

According to some critics the arguments which were advocated by MM, are not valued in the
practical world. We know that cost of capital and the value of the firm are practically the product
of financial leverage.

MM Hypothesis with Corporate Taxes and Capital Structure:

The MM Hypothesis is valid if there is perfect market condition. But, in the real world capital
market, imperfection arises in the capital structure of a firm which affects the valuation. Because,
presence of taxes invites imperfection.

We are, now, going to examine the effect of corporate taxes in the capital structure of a firm
along with the MM Hypothesis. We also know that when taxes are levied on income, debt
financing is more advantageous as interest paid on debt is a tax-deductible item whereas retained
earning or dividend so paid in equity shares are not tax-deductible.

Thus, if debt capital is used in the total capital structure, the total income available for equity
shareholders and/or debt holders will be more. In other words, the levered firm will have a higher
value than the unlevered firm for this purpose, or, it can alternatively be stated that the value of
the levered firm will exceed the unlevered firm by an amount equal to debt multiplied by the rate
of tax.

The same can be explained in the form of the following equation:

Illustration 4:

Assume:

Two firms—Firm ‘A’ and Firm ‘B’ (identical in all respects except capital structure)

Firm ‘A’ has financed a 6% debt of Rs. 1,50,000

Firm ‘B’ Levered

EBIT (for both the firm) Rs. 60,000

Cost of Capital is @ 10%

Corporate rate of tax is @ 60%

Compute market value of the two firms.

Thus, a firm can lower its cost of capital continuously due to the tax deductibility of interest
charges. So, a firm must use the maximum amount of leverage in order to attain the optimum
capital structure although the experience that we realise is contrary to the opinion.

In real-world situation, however, firms do not take a larger amount of debt and creditors/lenders
also are not interested to supply loan to highly levered firms due to the risk involved in it.
Thus, due to the market imperfection, after tax cost of capital function will be U-shaped. In
answer to this criticism, MM suggested that the firm would adopt a target debt ratio so as not to
violate the limits of level of debt imposed by creditors. This is an indirect way of stating that the
cost of capital will increase sharply with leverage beyond some safe limit of debt.

MM Hypothesis with corporate taxes can better be presented with the help of the following
diagram:

Leverage: Meaning and Its Types (With Formula)

Meaning of Leverage:

The word ‘leverage’, borrowed from physics, is frequently used in financial management.

The object of application of which is made to gain higher financial benefits compared to the
fixed charges payable, as it happens in physics i.e., gaining larger benefits by using lesser
amount of force.

n short, the term ‘leverage’ is used to describe the ability of a firm to use fixed cost assets or
funds to increase the return to its equity shareholders. In other words, leverage is the
employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of
interest obligation—irrespective of the level of activities attained, or the level of operating profit
earned.

Leverage occurs in varying degrees. The higher the degree of leverage, the higher is the risk
involved in meeting fixed payment obligations i.e., operating fixed costs and cost of debt capital.
But, at the same time, higher risk profile increases the possibility of higher rate of return to the
shareholders.

Some definitions are given to have a clear idea about leverage:

According to Ezra Solomon:

“Leverage is the ratio of net returns on shareholders equity and the net rate of return on
capitalisation”.

According to J. C. Van Home:

“Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed
return.”

Types of Leverage:

Leverage is of the three types:

(i) Operating leverage

(ii) Financial leverage and

(iii) Combined leverage

1. Operating Leverage:

Operating leverage refers to the use of fixed operating costs such as depreciation, insurance of
assets, repairs and maintenance, property taxes etc. in the operations of a firm. But it does not
include interest on debt capital. Higher the proportion of fixed operating cost as compared to
variable cost, higher is the operating leverage, and vice versa.

Operating leverage may be defined as the “firm’s ability to use fixed operating cost to magnify
effects of changes in sales on its earnings before interest and taxes.”

In practice, a firm will have three types of cost viz:

(i) Variable cost that tends to vary in direct proportion to the change in the volume of activity,

(ii) Fixed costs which tend to remain fixed irrespective of variations in the volume of activity
within a relevant range and during a defined period of time,

(iii) Semi-variable or Semi-fixed costs which are partly fixed and partly variable. They can be
segregated into variable and fixed elements and included in the respective group of costs.

Operating leverage occurs when a firm incurs fixed costs which are to be recovered out of sales
revenue irrespective of the volume of business in a period. In a firm having fixed costs in the
total cost structure, a given change in sales will result in a disproportionate change in the
operating profit or EBIT of the firm.

If there is no fixed cost in the total cost structure, then the firm will not have an operating
leverage. In that case, the operating profit or EBIT varies in direct proportion to the changes in
sales volume.

Operating leverage is associated with operating risk or business risk. The higher the fixed
operating costs, the higher the firm’s operating leverage and its operating risk. Operating risk is
the degree of uncertainty that the firm has faced in meeting its fixed operating cost where there is
variability of EBIT.
It arises when there is volatility in earnings of a firm due to changes in demand, supply,
economic environment, business conditions etc. The larger the magnitude of operating leverage,
the larger is the volume of sales required to cover all fixed costs.

Illustration 1:

A firm sells its product for Rs. 5 per unit, has variable operating cost of Rs. 3 per unit and fixed
operating costs of Rs. 10,000 per year. Its current level of sales is 20,000 units. What will be the
impact on profit if (a) Sales increase by 25% and (b) decrease by 25%?

(a) A 25% increase in sales (from 20,000 units to 25,000 units) results in a 33 1/3% increase in
EBIT (from Rs. 30,000 to Rs. 40,000).

(b) A 25% decrease in sales (from 20,000 units to 15,000 units) results in a 33 1/3% decrease in
EBIT (from Rs. 30,000 to Rs. 20,000).

The above illustration clearly shows that when a firm has fixed operating costs an increase in
sales volume results in a more than proportionate increase in EBIT. Similarly, a decrease in the
level of sales has an exactly opposite effect. The former operating leverage is known as
favourable leverage, while the latter is known as unfavorable.

Degree of Operating Leverage:

The earnings before interest and taxes (i.e., EBIT) changes with increase or decrease in the sales
volume. Operating leverage is used to measure the effect of variation in sales volume on the
level of EBIT.

The formula used to compute operating leverage is:

A high degree of operating leverage is welcome when sales are rising i.e., favourable market
conditions, and it is undesirable when sales are falling. Because, higher degree of operating
leverage means a relatively high operating fixed cost for recovering which a larger volume of
sales is required.

The degree of operating leverage is also obtained by using the following formula:

Degree of operating leverage (DOL) = Percentage change in EBIT / Percentage Change in Units
Sold.

The value of degree of operating leverage must be greater than 1. If the value is equal to 1 then
there is no operating leverage.

Importance of Operating Leverage:

The importance of operating leverage:

1. It gives an idea about the impact of changes in sales on the operating income of the firm.

2. High degree of operating leverage magnifies the effect on EBIT for a small change in the sales
volume.

3. High degree of operating leverage indicates increase in operating profit or EBIT.

4. High operating leverage results from the existence of a higher amount of fixed costs in the
total cost structure of a firm which makes the margin of safety low.

5. High operating leverage indicates higher amount of sales required to reach break-even point.

6. Higher fixed operating cost in the total cost structure of a firm promotes higher operating
leverage and its operating risk.

7. A lower operating leverage gives enough cushion to the firm by providing a high margin of
safety against variation in sales.

8. Proper analysis of operating leverage of a firm is useful to the finance manager.

2. Financial Leverage:

Financial leverage is primarily concerned with the financial activities which involve raising of
funds from the sources for which a firm has to bear fixed charges such as interest expenses, loan
fees etc. These sources include long-term debt (i.e., debentures, bonds etc.) and preference share
capital.

Long term debt capital carries a contractual fixed rate of interest and its payment is obligatory
irrespective of the fact whether the firm earns a profit or not.

As debt providers have prior claim on income and assets of a firm over equity shareholders, their
rate of interest is generally lower than the expected return in equity shareholders. Further,
interest on debt capital is a tax deductible expense.

These two facts lead to the magnification of the rate of return on equity share capital and hence
earnings per share. Thus, the effect of changes in operating profits or EBIT on the earnings per
share is shown by the financial leverage.

According to Gitman financial leverage is “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on firm’s earnings per share”. In other words, financial
leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to
the equity shareholders.

Favourable or positive financial leverage occurs when a firm earns more on the assets/
investment purchased with the funds, than the fixed cost of their use. Unfavorable or negative
leverage occurs when the firm does not earn as much as the funds cost.

Thus shareholders gain where the firm earns a higher rate of return and pays a lower rate of
return to the supplier of long-term funds. The difference between the earnings from the assets
and the fixed cost on the use of funds goes to the equity shareholders. Financial leverage is also,
therefore, called as ‘trading on equity’.

Financial leverage is associated with financial risk. Financial risk refers to risk of the firm not
being able to cover its fixed financial costs due to variation in EBIT. With the increase in
financial charges, the firm is also required to raise the level of EBIT necessary to meet financial
charges. If the firm cannot cover these financial payments it can be technically forced into
liquidation.

Illustration 2:

One-up Ltd. has Equity Share Capital of Rs. 5,00,000 divided into shares of Rs. 100 each. It
wishes to raise further Rs. 3,00,000 for expansion-cum-modernisation scheme.

The company plans the following financing alternatives:

(i) By issuing Equity Shares only.

(ii) Rs. 1,00,000 by issuing Equity Shares and Rs. 2,00,000 through Debentures @ 10% per
annum.

(iii) By issuing Debentures only at 10% per annum.

(iv) Rs. 1,00,000 by issuing Equity Shares and Rs. 2,00,000 by issuing 8% Preference Shares.
You are required to suggest the best alternative giving your comment assuming that the
estimated earnings before interest and taxes (EBIT) after expansion is Rs. 1,50,000 and corporate
rate of tax is 35%.

In the above example, we have taken operating profit (EBIT = Rs. 1,50,000) constant for
alternative financing plans. It shows that earnings per share (EPS) increases with the increase in
the proportion of debt capital (debenture) to total capital employed by the firm, the firm’s EBIT
level taken as constant.

Financing Plan I does not use debt capital and, hence, Earning per share is low. Financing Plan
III, which involves 62.5% ordinary shares and 37.5% debenture, is the most favourable with
respect to EPS (Rs. 15.60). The difference in Financing Plans II and IV is due to the fact that the
interest on debt is tax-deductible while the dividend on preference shares is not.

Hence, financing alternative III should be accepted as the most profitable mix of debt and equity
by One-up Ltd. Company.

Degree of Financing Leverage:

Financing leverage is a measure of changes in operating profit or EBIT on the levels of earning
per share.

It is computed as:

Financial leverage = Percentage change in EPS / Percentage change in EBIT = Increase in EPS /
EPS / Increase in EBIT/EBIT

The financial leverage at any level of EBIT is called its degree. It is computed as ratio of EBIT to
the profit before tax (EBT).

Degree of Financial leverage (DFL) = EBIT / EBT

The value of degree of financial leverage must be greater than 1. If the value of degree of
financial leverage is 1, then there will be no financial leverage. The higher the proportion of debt
capital to the total capital employed by a firm, the higher is the degree of financial leverage and
vice versa.

Again, the higher the degree of financial leverage, the greater is the financial risk associated, and
vice versa. Under favourable market conditions (when EBIT may increase) a firm having high
degree of financial leverage will be in a better position to increase the return on equity or earning
per share.

Importance of Financial Leverage:

The financial leverage shows the effect of changes in EBIT on the earnings per share. So it plays
a vital role in financing decision of a firm with the objective of maximising the owner’s wealth.

The importance of financial leverage:

1. It helps the financial manager to design an optimum capital structure. The optimum capital
structure implies that combination of debt and equity at which overall cost of capital is minimum
and value of the firm is maximum.

2. It increases earning per share (EPS) as well as financial risk.

3. A high financial leverage indicates existence of high financial fixed costs and high financial
risk.

4. It helps to bring balance between financial risk and return in the capital structure.

5. It shows the excess on return on investment over the fixed cost on the use of the funds.

6. It is an important tool in the hands of the finance manager while determining the amount of
debt in the capital structure of the firm.

3. Combined Leverage:

Operating leverage shows the operating risk and is measured by the percentage change in EBIT
due to percentage change in sales. The financial leverage shows the financial risk and is
measured by the percentage change in EPS due to percentage change in EBIT.

Both operating and financial leverages are closely concerned with ascertaining the firm’s ability
to cover fixed costs or fixed rate of interest obligation, if we combine them, the result is total
leverage and the risk associated with combined leverage is known as total risk. It measures the
effect of a percentage change in sales on percentage change in EPS.

Degree of Combined Leverage:

The combined leverage can be measured with the help of the following formula:

Combined Leverage = Operating leverage x Financial leverage

The combined leverage may be favourable or unfavorable. It will be favourable if sales increase
and unfavorable when sales decrease. This is because changes in sales will result in more than
proportional returns in the form of EPS. As a general rule, a firm having a high degree of
operating leverage should have low financial leverage by preferring equity financing, and vice
versa by preferring debt financing.

If a firm has both the leverages at a high level, it will be very risky proposition. Therefore, if a
firm has a high degree of operating leverage the financial leverage should be kept low as proper
balancing between the two leverages is essential in order to keep the risk profile within a
reasonable limit and maximum return to shareholders.

Importance of Combined Leverage:

The importance of combined leverage are:

It indicates the effect that changes in sales will have on EPS.

2. It shows the combined effect of operating leverage and financial leverage.

3. A combination of high operating leverage and a high financial leverage is very risky situation
because the combined effect of the two leverages is a multiple of these two leverages.

4. A combination of high operating leverage and a low financial leverage indicates that the
management should be careful as the high risk involved in the former is balanced by the later.

5. A combination of low operating leverage and a high financial leverage gives a better situation
for maximising return and minimising risk factor, because keeping the operating leverage at low
rate full advantage of debt financing can be taken to maximise return. In this situation the firm
reaches its BEP at a low level of sales with minimum business risk.

6. A combination of low operating leverage and low financial leverage indicates that the firm
losses profitable opportunities.

EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and
shows ways to maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial
planning that evaluates various alternatives of financing a project under varying levels of EBIT
and suggests the best alternative having highest EPS and determines the most profitable level of
EBIT’.

Concept of EBIT-EPS Analysis:

The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative
methods of financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the
effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial
plans.

It examines the effect of financial leverage on the behavior of EPS under different financing
alternatives and with varying levels of EBIT. EBIT-EPS analysis is used for making the choice
of the combination and of the various sources. It helps select the alternative that yields the
highest EPS.

We know that a firm can finance its investment from various sources such as borrowed capital or
equity capital. The proportion of various sources may also be different under various financial
plans. In every financing plan the firm’s objectives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis:

We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior
of EPS under various financing plans with varying levels of EBIT. It helps a firm in determining
optimum financial planning having highest EPS.

Various advantages derived from EBIT-EPS analysis may be enumerated below:

Financial Planning:

Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial
planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evaluates the
alternatives and finds the level of EBIT that maximizes EPS.

Comparative Analysis:

EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines
and markets. It identifies the EBIT earned by these different departments, product lines and from
various markets, which helps financial planners rank them according to profitability and also
assess the risk associated with each.

Performance Evaluation:

This analysis is useful in comparative evaluation of performances of various sources of funds. It

evaluates whether a fund obtained from a source is used in a project that produces a rate of return
higher than its cost.

Determining Optimum Mix:

EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By
emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt and
equity in the capital structure. It helps determine the alternative that gives the highest value of
EPS as the most profitable financing plan or the most profitable level of EBIT as the case may
be.

Limitations of EBIT-EPS Analysis:

Finance managers are very much interested in knowing the sensitivity of the earnings per share
with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this
technique also suffers from certain limitations, as described below

No Consideration for Risk:

Leverage increases the level of risk, but this technique ignores the risk factor. When a
corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any
financial planning can be accepted irrespective of risk. But in times of poor business the reverse
of this situation arises—which attracts high degree of risk. This aspect is not dealt in EBIT-EPS
analysis.

Contradictory Results:

It gives a contradictory result where under different alternative financing plans new equity shares
are not taken into consideration. Even the comparison becomes difficult if the number of
alternatives increase and sometimes it also gives erroneous result under such situation.

Over-capitalization:

This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point,
additional capital cannot be employed to produce a return in excess of the payments that must be
made for its use. But this aspect is ignored in EBIT-EPS analysis.

Example 5.1:

Ankim Ltd., has an EBIT of Rs 3, 20,000. Its capital structure is given as under:
Indifference Points:

The indifference point, often called as a breakeven point, is highly important in financial
planning because, at EBIT amounts in excess of the EBIT indifference level, the more heavily
levered financing plan will generate a higher EPS. On the other hand, at EBIT amounts below
the EBIT indifference points the financing plan involving less leverage will generate a higher
EPS.

i. Concept:

Indifference points refer to the EBIT level at which the EPS is same for two alternative financial
plans. According to J. C. Van Home, ‘Indifference point refers to that EBIT level at which EPS
remains the same irrespective of debt equity mix’. The management is indifferent in choosing
any of the alternative financial plans at this level because all the financial plans are equally
desirable. The indifference point is the cut-off level of EBIT below which financial leverage is
disadvantageous. Beyond the indifference point level of EBIT the benefit of financial leverage
with respect to EPS starts operating.

The indifference level of EBIT is significant because the financial planner may decide to take the
debt advantage if the expected EBIT crosses this level. Beyond this level of EBIT the firm will
be able to magnify the effect of increase in EBIT on the EPS.

In other words, financial leverage will be favorable beyond the indifference level of EBIT and
will lead to an increase in the EPS. If the expected EBIT is less than the indifference point then
the financial planners will opt for equity for financing projects, because below this level, EPS
will be more for less levered firm.

ii. Computation:

We have seen that indifference point refers to the level of EBIT at which EPS is the same for two
different financial plans. So the level of that EBIT can easily be computed. There are two
approaches to calculate indifference point: Mathematical approach and graphical approach.

Mathematical Approach:

Under the mathematical approach, the indifference point may be obtained by solving equations.
Let us present the income statement given in Table 5.1 with the following symbols in Table 5.4.

We are starting from EBIT only.

Where, N represents number of equity shares.

In case of financing, three types of sources may be opted: Equity, debt and preference shares. So
we may have four possible combinations Equity, Equity-Debt, Equity- Preference Shares and
Equity- Debt-Preference Shares.

So, EPS under various alternatives will be as follows:

Note:

The symbols have their usual meaning.

The indifference point between any two financial plans may be obtained by equalizing the
respective equations of EPS and solving them to find the value of X.

Example 5.2:

Debarathi Co. Ltd., is planning an expansion programme. It requires Rs 20 lakhs of external

financing for which it is considering two alternatives. The first alternative calls for issuing
15,000 equity shares of Rs 100 each and 5,000 10% Preference Shares of Rs 100 each; the
second alternative requires 10,000 equity shares of Rs 100 each, 2,000 10% Preference Shares of
Rs 100 each and Rs 8,00,000 Debentures carrying 9% interest. The company is in the tax bracket
of 50%. You are required to calculate the indifference point for the plans and verify your answer
by calculating the EPS.

Solution:
Graphical Approach:

The indifference point may also be obtained using a graphical approach. In Figure 5.1 we have
measured EBIT along the horizontal axis and EPS along the vertical axis. Suppose we have two
financial plans before us: Financing by equity only and financing by equity and debt. Different
combinations of EBIT and EPS may be plotted against each plan. Under Plan-I the EPS will be
zero when EBIT is nil so it will start from the origin.

The curve depicting Plan I in Figure 5.1 starts from the origin. For Plan-II EBIT will have some
positive figure equal to the amount of interest to make EPS zero. So the curve depicting Plan-II
in Figure 5.1 will start from the positive intercept of X axis. The two lines intersect at point E
where the level of EBIT and EPS both are same under both the financial plans. Point E is the
indifference point. The value corresponding to X axis is EBIT and the value corresponding to 7
axis is EPS.

These can be found drawing two perpendiculars from the indifference point—one on X axis and
the other on Taxis. Similarly we can obtain the indifference point between any two financial
plans having various financing options. The area above the indifference point is the debt
advantage zone and the area below the indifference point is equity advantage zone.

Above the indifference point the Plan-II is profitable, i.e. financial leverage is advantageous.
Below the indifference point Plan I is advantageous, i.e. financial leverage is not profitable. This
can be found by observing Figure 5.1. Above the indifference point EPS will be higher for same
level of EBIT for Plan II. Below the indifference point EPS will be higher for same level of
EBIT for Plan I. The graphical approach of indifference point gives a better understanding of
EBIT-EPS analysis.
Financial Breakeven Point:

In general, the term Breakeven Point (BEP) refers to the point where the total cost line and sales
line intersect. It indicates the level of production and sales where there is no profit and no loss
because here the contribution just equals to the fixed costs. Similarly financial breakeven point is
the level of EBIT at which after paying interest, tax and preference dividend, nothing remains for
the equity shareholders.

In other words, financial breakeven point refers to that level of EBIT at which the firm can
satisfy all fixed financial charges. EBIT less than this level will result in negative EPS. Therefore
EPS is zero at this level of EBIT. Thus financial breakeven point refers to the level of EBIT at
which financial profit is nil.

Financial Break Even Point (FBEP) is expressed as ratio with the following equation:

Example 5.3:

A company has formulated the following financing plans to finance Rs 15, 00,000 which is
required for financing a new project.