FINANCIAL MANAGEMENT

CHAPTER 7

CAPITAL STRUCTURE

Learning Objectives
After reading this unit, you will be able to:
·State the meaning of capital structure
·Explain significance of capital structure
·Identify the importance and factors of optimum capital structure
·Specify the effect of capital structure on profitability and liquidity of firm

Structure
7.1 Introduction
7.2 Meaning of Capital Structure
7.3 Significance of Capital Structure
7.4 Optimum Capital Structure
7.5 Various Aspects Of Capital Structure
7.6 Summary

7.1 Introduction

Every company collects funds from different sources. Right mix of various
sources of long-term funds is necessary to keep cost of funds to minimum and
at the same time, company should be able to make maximum use of funds.
Capital structure is the mix of long-term sources of funds. This unit deals with
various aspects of capital structure.

7.2 Meaning Of Capital Structure

. It refers to the mix of long term finances used by company.

. Capital structure may be the combination of equity and one or more of the
following in different proportion :
– Debentures
– Preference shares
– Long term loans
. Capital structure is different from financial structure of company. While
former is a mix of long funds, later is a mix of long-term funds and current
liabilities of company.
. Company should plan its capital structure to maximize use of funds and to
be able to adapt more quickly to changing business conditions.

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7.3 Significance Of Capital Structure

Having proper capital structure is important for following reasons:

· Optimum capital structure is useful for maximizing Earning Per Share (E.P.S.)
and Market Value Per Share (M.V.P.S.).
· Liquidity and profitability of company is affected by capital structure decision.
· Control over the company is defined by its capital structure.
· Capital budgeting and capital structure decision are closely related to each
other.
· Capital structure decision is taken at the time of formation of company or at
the time of expansion and diversification of business.

7.4 Optimum Capital Structure

Company always likes to have optimum capital structure because at this point.
- E.P.S. is maximum.
- Cost of capital is minimum.
Following factors are to be considered while designing optimum capital
structure for company:
(1) Maximization of profitability
· Capital structure should be most profitable for equity shareholders.
· Within given constraints maximum debt financing should be adopted to
increase the returns available to equity shareholders.
· E.P.S. should be maximized.
(2) Minimization of risk
Capital structure must be consistent with business risk and financial risk.
Business Risk:
a) It is the relationship between revenue and E.B.I.T. of company.
b) Business risk is high when:
- E.B.I.T. changes (up or down) as compared to sales of company
- Company has more fixed costs
- Costs and revenues are not stable.
Financial Risk :
a) This risk arises when company uses debt capital and preference capital in
capital structure.
Capital structure may be called as sound if it keeps the total risk of the
company [i.e. Business Risk + Financial Risk] to minimum level.
Excessive use of debt affects long-term solvency and financial risk and this
must be assessed for a given capital structure.
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(3) Flexibility
It refers to ability of company to raise additional capital funds whenever
needed to finance profitable and viable investment opportunities.
Flexibility implies that a capital structure should always have an untapped
borrowing capacity, which can be used any time in future.
(4) Capacity
The capital structure should be determined within debt raising capacity of the
company.
The debt capacity of company depends on its ability to generate future cash
flows.
Company should have enough cash to pay fixed charges and principal sum of
creditors.

(5) Control
Control is the most important aspect of corporate management. Ultimate
control of company affairs is in the hands of equity shareholders. For dealing
with controlling aspects while deciding capital structure, following points must
be kept in mind:
· Capital structure should reflect the philosophy of control of management.
· While redeemable debentures do not result in dilution of control, convertible
debentures result in dilution of control when converted in equity shares.
· Convertible preference shares and convertible loans from banks or financial
institutions result in dilution of control.
· Preference capital and debt financing do not dilute controlling powers of
management.

(6) Simplicity
Capital structure must be simple to operate and easy to understand.
Administrative convenience must be maximum.
Rights attached with each type of security must be clearly spelt.

(7) Economy
Capital structure should be economical from point of view of:
· Floatation cost i.e. cost of floating capital.
· Operation cost, i.e. servicing equity, preference and debenture holders, to be
paid to underwriters and brokers.
· Commissions and brokerage.

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7.5 Various Aspects Of Capital Structure

A] Profitability and Capital Structure: [EBIT-EPS analysis]

Finance manager must study various alternative financial leverages and find
their effect on E.P.S. of Co. When rate of return on assets employed in
business is more than cost of their financing EPS increases and it is favorable
financial leverage. When rate of return on assets employed in business is less
than cost of their financing EPS decreases and it is unfavorable financial
leverage.
Fixed financial charge financing must be analyzed with reference to choice
between debt and preference shares. Generally, rate of interest payable to
debt instruments or loans is lower than dividend payable on preference
shares. Interest payable on debt is tax deductible whereas dividend on
preference shares is paid from P.A.T. When various options are available to
company, the action that gives maximum E.P.S. should be selected. Risk
attached with leverage may be incorporated in analysis. Find indifferent level
of EBIT, i.e. level of EBIT for which EPS is same for different capital structure by
formula:
( EBIT - I1 ) ( 1 – T ) = (EBIT - I2 ) ( 1 – T )
E1 E2
EBIT = Earnings before interest and tax
I1 = Interest charges in alternative 1
I2 = Interest charges in alternative 2
E1 = No. of Equity shares in alternative 1
E2 = No. of Equity shares in alternative 2
Compare expected EBIT with indifference level.
a) When expected EBIT is more than indifferent EBIT debt financing is
advantageous.
b) When expected EBIT is less than indifferent EBIT debt financing is risky.
Greater the difference between the two more the advantageous or risky is the
debt financing. In EBIT –EPS analysis debt capacity of the firm for debt service
and interest service and effect on liquidity of company must be incorporated.
B] Liquidity and Capital Structure (Cash flow analysis)
Company though earning sufficient profits may not be generating large
enough cash surplus perhaps due to needs to reinvest heavily in working
capital. Such a firm finds it difficult to service fixed interest and preference
dividend. In such case, company may resort to equity finance where dividends
can be paid based on cash position.
Companies, which can generate large cash surplus from their operations, will
tend to opt, for large debt financing.

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Finance manager, while evaluating different capital structures, should ensure

liquidity for:
I) Interest on debt
ii) Repayment of debt
iii) Dividend on Preference capital
iv) Redemption of Preference capital
Liquidity can be ascertained from:
I) Debt service coverage ratio (DSCR)
DSCR = P.A.T. + DEP. + Interest + Non-Cash Expenses __
Preference dividend + Interest + Repayment obligation
This ratio helps in assessing the extent to which cash profits of the firm covers
the cash payments of revenue and capital nature. Higher DSCR better is the
liquidity of company.
II) From projected cash flow analysis:
If cash inflows are comfortably higher than cash outflows then company can
proceed with debt financing. Cash inflows and outflows should be assessed
under varying operating conditions along with their probabilities.
Illustration 1:
Company is in the process of undertaking new project worth Rs. 2,000 crore.
Four alternatives are available to company. [Amt. Rs. Crore]
Alternative Equity Preference (8%) Debenture (10%) Loan (12%)
I 300 100 800 800
II 400 200 700 700
III 600 300 600 500
IV 800 400 500 300
Company expects E.B.I.T. of 15% on capital employed. Tax applicable to
company is 40%. Which alternative should be selected on basis of E.P.S.
Solution:
E.B.I.T. expected = 15% of Rs. 2,000 crore = Rs. 300 crore
Company should select the alternative that gives maximum E.P.S. It is
therefore necessary to calculate E.P.S. under all four alternatives.

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[Amt. Rs. Crore]

Alternative I II III IV
-------------------------------------------------------------------------------------------------
Equity Capital 300 400 600 800
Preference Capital (8%) 100 200 300 400
Debentures (10%) 800 700 600 500
Loan (12%) 800 700 500 300
Total 2,000 2,000 2,000 2,000
E.B.IT. 300 300 300 300
(-)Interest on debentures 80 70 60 50
Interest on loan 96 84 60 36
=E.B.T. 124 146 180 214
(-)Tax (40%) 49.60 58.40 72 85.60
=E.A.T. 74.40 87.60 108 128.40
(-)Pref. Dividend 8 16 24 32
=Amount available
to equity shareholders (a) 66.40 71.60 84 96.40
No. of equity shares (b) 30 40 60 80
(In crore)
E.P.S. = a 2.21 1.79 1.40 1.21
Note:
When nothing is mentioned, it is to be assumed that each equity share is of
Rs. 10.
Interest is paid by company on debentures and loan before tax is paid.
Dividend is paid on preference capital after tax is paid.
Since E.P.S. is maximum for alternative number 1, company should select this
alternative.
Equity capital Rs. 300 crore
Preference Capital (8%) Rs. 100 crore
Debentures (10%) Rs. 800 crore
Loan (12%) Rs. 800 crore
Illustration 2
Company has two alternatives of capital structure for its expansion plan, which
require Rs. 150 crore.
Alternative A: Rs.60 crore Equity, Rs. 40 crore Debentures (12%) and
remaining by loan.
Alternative B: Rs.80 crore Equity, Rs. 50 crore Debentures (12%) and
remaining by loan.
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Interest on loan is as under:

Up to Rs. 5 crore - 10%
5 crore to 20 crore - 11%
More than 20 crore - 13%
Expected E.B.I.T. is Rs. 35 crore. Tax is 40%. Company has corporate
objective of maximizing company's wealth. P/E ratio expected is 8 for
alternative A and 9 for alternative B.
Advice the company on appropriate capital structure.
Solution:

[Amt. Rs. in Crore]

Alternative A B
Equity Capital 60 80
Debentures (12%) 40 50
Loan 100 70
Total 200 200
E.B.I.T. 35 35
(-)Interest 12.55 8.65
=E.B.T. 22.45 26.35

(-) Tax (40%) 8.98 10.54

=E.A.T. 13.47

(-) Pref. Dividend NIL NIL

=Amt. to Equity shareholders 13.47 15.81
(a)
No. of equity shares (b) 6 8
(in crore.)
E.P.S.=[a/b] 2.25 1.98

P/E 8 9

M.V.P.S. = E.P.S. x P/E 18 17.82

Market capitalization 108 142.56

= M.V.P.S. x No. of equity shares

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Notes:
1) Calculation of Interest
For alternative A:
First – Rs. 5 Crs. @ 10% = Rs. 0.5 Crs.
Next Rs. 15 Crs. @ 11% = Rs. 1.65 Crs.
Next Rs. 80 Crs. @ 13% = Rs. 10.40 Crs.
Total Rs. 12.55 Crs.
For alternative B:
First Rs. 5 Crs. @ 10% = Rs. 0.5 Crs.
Next Rs. 15 Crs. @ 11% = Rs. 1.65 Crs.
Next Rs. 50 Crs. @ 13% = Rs. 6.50 Crs.
Total = Rs. 8.65 Crs.
2) Market Value per Share (M.V.P.S.)= (P/E) x (E.P.S.)
3) Wealth of company is nothing but market capitalization.
Hence, the alternative that maximizes market capitalization should be
selected.
4) Each equity share is of Rs. 10 unless otherwise stated.
5) If wealth of shareholders is to be maximized then select alternative with
maximum M.V.P.S.
Ans.: Management should select alternative B, since market capitalization is
maximum.
Management should select alternative A if wealth of shareholders is to be
maximized.
7.6 Summary
· Capital structure is composition of company's long-term capital.
· Optimum capital structure ensures maximum profitability, minimizing risk,
flexibility, control and at the same time keeps capital structure to be simple
and debt raising capacity to be intact.
· Profitability and liquidity of company is affected by capital structure
decision.

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