EQUITY

DEBT FINANCIAL MARKETS

AND INSTITUTIONS

TOPIC 5:
FIRM’S CAPITAL
STRUCTURE

PREPARED BY GROUP 5
QUESTION:
WHERE DO FIRM’S
GET THEIR SOURCE
OF FUNDS?
 TOPIC 5: OUTLINE
1. Capital Structure:
* Capital: Definition
* Capital Structure: Definition
* Capital Structure: Why it Changes Over time?
2. External Assessment of Capital Structure
3. Capital Structure Theory
a. Traditional Approach
b. F. Modigliani and M. Miller
 TOPIC 5: OUTLINE

4. Optimal Structure Theory

5. EBIT-EPS Approach to Capital Structure
6. Considering Risk in EBIT-EPS Analysis
7. Basic Shortcoming of EBIT-EPS Analysis
8. Choosing the Optimal Capital Structure
 CAPITAL
STRUCTURE
 CAPITAL: DEFINED
• Capital is anything that increases one’s
ability to generate value or confer value and
benefit to its owners.
• It’s a broad term that can be used to
increase value across a wide range of
categories, such as financial, social, physical,
intellectual, etc.
• Capital is a critical component of running a
business from day to day and financing its
future growth.
 DEFINITION:
CAPITAL STRUCTURE

• Capital structure refers to the amount of

debt and/or equity employed by a firm
to fund its operations and finance its
assets. A firm’s capital structure is
typically expressed as a debt-to-equity or
debt-to-capital ratio.

• There is a so-called Optimal Capital

Structure to be discussed later on.
 TYPES OF CAPITAL
STRUCTURE

1. DEBT CAPITAL 3. WORKING CAPITAL

2. EQUITY CAPITAL 4. TRADING CAPITAL
 DEBT CAPITAL

• Capital that is obtained through borrowing

from either private or government sources.

• Small businesses may borrow from friends or

family, online lenders, credit card companies,
and federal loan programs.

• Established companies in the meantime may

borrow from banks, other financial institutions,
or issue bonds.
 EQUITY CAPITAL
• These are funds paid into a business by
investors in exchange for common stock
or preferred stock.

• These stocks allow investors to possibly

have control over the business once a
certain amount of shares are owned,
dividends, and appreciation.
 WORKING CAPITAL
• A company's working capital is its liquid
capital assets available for fulfilling daily
obligations. It is a prime measure of the
short-term liquidity of an organization.

Question:
- What is the Formula of Working Capital?
 TRADING CAPITAL

• it is the amount of money allocated

to an individual or a firm to buy and
sell various securities.

• Trading capital is a term used by

brokerages and other financial
institutions that place a large number
of trades daily.
CAPITAL STRUCTURE:
WHY IT CHANGES OVER
TIME?
 CAPITAL STRUCTURE:
WHY IT CHANGES OVER TIME?

A. Company Growth / Expansion of

Operations
B. Nature of Business / Industry
C. Management Strategy
D. Market Conditions
E. Changes made from Regulatory Authorities
F. Reorganization from the firm
- Internal Reorganization (Recapitalization)
- External Reorganization (Mergers/Acq.)
 COMPANY GROWTH
• To Maximize the growth of the company.
• How would the firm gather financial resources
to expand its operations?

1. Revenues?
2. Issue New Shares? Or Equity Financing?
3. Use Earnings from Other Investments?

• The Optimal Option now is to get Debt

Financing from the Financial Institutions such
as Banks, Financial Intermediaries and Others.
B. NATURE OF BUSINESS
• Firms in different industries will use
capital structures better suited to their
type of business.

C. MANAGEMENT STRATEGY

• Management of the firm plays an important

role in achieving its Business goals

D. MARKET CONDITION
• Changes in interest rates, economic conditions,
and investor sentiment can influence a company’s
decision to adjust its capital structure.
E. REGULATORY AUTHORITIES

• Changes in regulations or tax laws can

impact the attractiveness of debt versus
equity financing. (Ex. CREATE LAW - 2021)

F. FIRM’S REORGANIZATION

• There are 2 instances of Reorganization:

1. Internal (Changes in Management)
2. External (Mergers / Acquisition / Bus
Comb.)
 EXTERNAL
ASSESSMENT OF
CAPITAL STRUCTURE
 EXTERNAL ASSESSMENT
• A method used by outsiders to evaluate
a company's financial health by looking
at its capital structure.
Methods:
1. Debt Ratio
2. Interest Coverage Ratio
3. Industry and Business Line Differences
4. Global Comparison
5. Leverage's Effect
 EXTERNAL ASSESSMENT

1. Debt Ratio - It’s calculated as (Debt ÷

(Debt + Equity)

2. Interest It’s calculated as Earnings

Coverage Ratio Before Interest and Taxes
(EBIT) divided by interest
expenses (EBIT ÷ Interest).
 EXTERNAL ASSESSMENT

Different industries have

3. Industry and Business different levels of acceptable
Line Differences debt.
Other companies often have
4. Global Comparison higher debt ratios due to
differences in financing options.
Financial leverage (using debt)
5. Leverage's Effect can increase returns if used
wisely.
CAPITAL STRUCTURE
THEORY
 CAPITAL FINANCIAL
STRUCTURE STRUCTURE

• It includes only the long-term • It includes both long-term and

sources of funds short-term sources of funds.
• It means only the long-term • It means the entire liabilities
liabilities of the company side of the balance sheet.

• It consists of equity, preference, • Consists of all sources of

and retained earning capital capital

• It is one of the major • It will not be more important

determinations of the value of while determining the value of
the firm firm
 CAPITAL
STRUCTURE

NET INCOME NET OPERATING

APPROACH INCOME APPROACH
 TRADITIONAL
APPROACH
• The traditional approach to capital structure
advocates that there is a right combination of
equity and debt in the capital structure, at
which the market value of a firm is maximum.

• As per this approach, debt should exist in the

capital structure only up to a specific point,
beyond which any increase in leverage would
result in a reduction in the value of the firm.
 F. MODIGLIANI AND M. MILLER
• The Modigliani and Miller approach to capital theory,
devised in the 1950s, advocates the capital structure
irrelevancy theory.
• This suggests that the valuation of a firm is irrelevant to
a company’s capital structure.
• Whether a firm is high on leverage or has a lower debt
component has no bearing on its market value.
• Instead, the market value of a firm is solely dependent
on the operating profits of the company.
 THE M&M APPROACH

• This approach is based upon certain

assumptions to be considered:
1. These are no corporate taxes
2. There is a perfect markets
3. Investors act rationally
4. The expected earnings of all firm have
identical risk
5. All earnings are distributed to the shareholders
OPTIMAL STRUCTURE
THEORY
 OPTIMAL STRUCTURE
THEORY
• It is the mix of debt, preferred stock,
and common equity that maximizes the
stock’s intrinsic value. Maximizes the
intrinsic value also minimizes the WACC
(Weighted Average Cost of Capital).
 OBJECTIVES:
• The decision on capital structure aims at
the following TWO Important Objectives:

• 1. Maximize the value of the firm.

• 2. Minimize the overall cost of capital.

 FACTORS DETERMINING THE
OPTIMAL CAPITAL
STRUCTURE
1. Leverage
- It uses fixed – cost financing such as debt,
equity, and preference share capital.

2. Cost of Capital
- When the cost of capital increases, the
value of the firm will also decrease. Hence
the firm must take careful steps to reduce
the cost of capital.
 FACTORS DETERMINING
THE OCS
• Cost of Capital Includes also the factor:
(a) Nature of the business
(b) Size of the Company
(c) Legal Requirement
(d) Requirements of Investors

• 3. Government policy
- the company must consider government policy
regarding the capital structure. It includes Tax
Policies, Regulations,Economic policies and the
Government subsidies and grants.
 EBIT – EPS
APPROACH TO
CAPITAL STRUCTURE
 EBIT – EPS APPROACH
• It is a tool businesses use to determine the
best ratio of debt and equity that should be
used to finance the business' assets and
operations.
• At its core, the EBIT-EPS approach is a way
to mathematically project how a balance
sheet's structure will impact a company's
earnings.
• focuses on finding a capital structure with
the highest EPS over the expected range of
EBIT.
BASIC CONCEPT OF EBIT – EPS
APPROACH / ANALYSIS

EBIT – EARNINGS BEFORE

INTERESTS AND TAXES

EPS – EARNINGS PER SHARE

BASIC CONCEPT OF EBIT – EPS
APPROACH / ANALYSIS
• EBIT - This metric strips out the impact of
interest and taxes, showing how a company
is performing excluding the impacts of the
balance sheet's composition.

• EPS stands for earnings per share, which is

the profit the company generates including
the impact of interest and tax obligations.

• EPS is particularly helpful to investors

because it measures profits on a per share
basis.
 EBIT – EPS APPROACH
FORMULA:
Revenues XX_
COGS (XX)
Gross Profit XX_
Expenses (Ex. I&T) (XX)
EBIT XX
Int. & Taxes (XX)
Net Income XX
CONSIDERING RISK IN
EBIT – EPS ANALYSIS
 RISKS CONSIDERED IN
EBIT-EPS ANALYSIS

1. It does not first consider the Risk in EBIT

- Sales risk - Uncertainty about the firm’s sales.
- Operating risk - Uncertainty in operating
income caused by fixed operating costs.

2. Prioritizes Maximization of EPS

- which large short-term earnings will be
beneficial to the company for a short period of
time, but will be disadvantageous in the long
run.
 RISKS CONSIDERED IN
EBIT-EPS ANALYSIS

3. Economic Factors (Interest Rates, Etc.)

- interest rates fluctuate constantly which makes
it more riskier and unstable, resulting in lower
revenues and earnings which will be reflected in
a lower stock price.

4. Recapitalization (Over-Capitalization)
- High equity doesn’t signify that an entity is
generating revenue, it only makes the company
look more valuable than what it is perceived to
be.
BASIC SHORTCOMING
OF EBIT – EPS
ANALYSIS
 SHORTCOMINGS OF
EBIT – EPS APP.
• As firm obtains more debt (its financial
leverage increases), the risk also increases and
shareholders will require higher returns to
compensate for the increased financial risk.

• Therefore, this approach is not completely

appropriate because it does not consider one
of the key variables (risk), which is necessary
for maximization of shareholders’ wealth.
 LIMITATIONS
(i) No Consideration for Risk
- Leverage increases the level of risk In effect,
It is when the firm incurs more interest
expense, which it did not consider.
(ii) Contradictory Results
- Under different alternative financing plans
new equity shares are not taken into
consideration.
(iii) Over-capitalization
- Additional capital cannot be employed to
produce a return in excess of the payments
that must be made for its use.
 CHOOSING
THE OPTIMAL
CAPITAL STRUCTURE
 OPTIMAL CAPITAL
STRUCTURE
• Optimal Capital Structure is the best mix of
debt and equity financing that maximizes a
company’s market value while minimizing
its cost of capital and minimizing the
Weighted Average Cost of Capital is one
way to optimize the lowest cost mix of
financing.
• Lower Cost of Capital -> Higher Firm
Valuation
• Higher Cost of Capital -> Lower Firm
Valuation
 WHAT DETERMINES THE OCS?

• Corporate Life Cycle

- The capital structure of a company tends to
shift toward a greater proportion of debt as
opposed to equity in the latter stages of its
lifecycle.

• Tax-Deductibility of Interest
- Given the tax-deductibility of interest
expense – where interest reduces the pre-tax
income (EBT) line item on the income
statement – an increase in leverage causes the
firm valuation to initially rise.
WHAT DETERMINES THE OCS?

• Business Risk
- It is the risk inherent to the operating
performance of a firm, assuming no debt.

• Bankruptcy Risk
- is the likelihood that a company will be
unable to meet its debt obligations. It is
the probability of a firm becoming
insolvent due to its inability to service its
debt.
 WHAT DETERMINES THE OCS?

• Agency Costs
- Are the risk of discrepancies forming
between management and stakeholders,
which is often termed the principal-agent
problem, where differences in viewpoints can
cause the company to incur steep losses (and
a reduction in valuation).
• Lender Risk-Appetite (Tolerance)
- The aggregate level and types of risk a
financial institution is willing to assume within
its risk capacity to achieve its strategic
objectives and business plan.
THANK
YOU

ANY QUESTIONS?