FINANCIAL SOURCING AND ANALYSIS

(Capital Structure)
 CAPITAL STRUCTURE

 According to Gerstenberg, capital structure refers to

“the makeup of a firm’s capitalization”.

 It represents the mix of different sources of long-

term funds in the total capitalization of the company.

(equity shares + preference shares + long-term loans

+ retained earnings)
 Capital
Structure

Preference Retained
Equity Debt
Share Earnings

All kinds
of Loans

(Equity shares + Preference shares + Debt + Retained earnings)

 Example (a)

Preference Retained
Equity Loan
Share Earning

1,00,000 1,00,000 1,00,000 20,000

Capital Structure 3,20,000

 Example (b)

Preference Retained
Equity Loan
Share Earning

1,00,000 1,00,000 1,00,000 20,000

Capital Structure 1,00,000

 Example (C)

Preference Retained
Equity Loan
Share Earning

1,00,000 1,00,000 1,00,000 20,000

Capital Structure 2,00,000

 Example (b)

Preference Retained
Equity Loan
Share Earning

1,00,000 1,00,000 1,00,000 20,000

Capital Structure 3,00,000

 Difference between Capital Structure and
Financial Structure

Financial Structure Capital Structure

 Financial structure refers to the way the  A company’s capital structure is only a part of its
firm’s assets are financed. financial structure.

 It includes both long-term as well as  Capital structure is the permanent financing of

short-term sources of funds. the company represented primarily by long-term

debt and shareholders’ funds but excluding all
short-term credit.
 Patterns of Capital Structure

CAPITAL
STRUCTURE

Equity Share
Equity Shares Equity Shares +
Equity Shares + + Preference Shares
Preference Shares Debentures +
Debentures
 Optimum Capital Structure

 Capital structure is also known as debt and equity ratio in the capital of a company.

 Debt is a liability on which interest has to be paid irrespective of the company’s profits. While equity
consists of shareholders, or owners, funds on which payment of dividend depends upon the
company’s profits.

 A high proportion of the debt content in the capital structure increases the risk and may lead to
financial insolvency of the company in adverse times.

 However, raising funds through debt is cheaper as compared to raising funds through shares. This is
because interest on debt is allowed as an expense for tax purposes.
 Optimum Capital Structure cont….

 Dividend is considered to be an appropriation of profits hence payment of dividend does not result in any
tax benefit to the company.
 Thus, raising of funds by borrowing is cheaper resulting in higher availability of profits for shareholders.
This increases the earnings per equity share of the company which is the basic objective of a financial manager.
A firm should try to maintain an optimum capital structure with a view to maintain financial stability.
 The optimum capital structure is obtained when the market value per equity share is the maximum. It may,
therefore, be defined as that relationship of debt and equity securities which maximizes the value of a company’s
share in the stock exchange.
 Optimum Capital Structure cont….

 In case a company borrows and this borrowing helps in increasing the value of the company’s
shares in the stock exchange, it can be said that the borrowing has helped the company in moving
towards its optimum capital structure.

 In case the borrowing results in fall in the market value of the company’s equity shares, it can
be said that the borrowing has moved the company away from its optimum capital structure.

 The objective of the firm should therefore be to select a financing or debt-equity mix which will
lead to maximum value of the firm.
 Earnings Before Interest and Tax
(EBIT )

 EBIT (earnings before interest and taxes) is a company's net income

before income tax expense and interest expenses are deducted.
  EBIT is used to analyse the performance of a company's core
operations without the costs of the capital structure and tax expenses
impacting profit.
 Profit Before Tax (PBT) and Profit
After Tax (PAT)
PBT PAT

A measure that looks at a company's profits The total amount that a business

before the company has to pay corporate income earns after all tax deductions have taken place.
tax. It essentially is all of a company’s profits  Profit after tax is also seen as a measure of a
without the considerations of any taxes. company's profitability after all its expenses
have been deducted and can be fully utilised by
the company to conduct its business.
 Earning Per Share

Earnings per share (EPS) is a figure describing a public company’s profit

per outstanding share of stock calculated on a quarterly or annual basis. EPS

is arrived at by taking a company's quarterly or annual net income and

dividing by the number of its shares of stock outstanding.

 The effect of the change in debt-equity
mix on EPS of the company

 A Ltd has a share capital of Rs. 1,00,000 divided into shares of Rs 10 each. It has a major expansion programme
requiring and investment of another Rs 50,000. The management is considering the following alternatives for raising
this amount:
 Issue of 5,000 equity shares of Rs 10 each.
 Issue of 5,000, 12% preference shares of Rs 10 each.
 Issue of 10% debentures of Rs 50,000.

 The company’s present earnings before interest and tax (EBIT) are Rs 40,000 p.a. Calculate the effect of each of the
above modes on financing of the earnings per share (EPS) presuming:
 EBIT continues to be the same even after expansion.

 EBIT increases by Rs 10,000.

 Calculation of Earning Per Share if EBIT remains
same after the Expansion
PRESENT AND PROJECTED EARNING PER SHARE Total capital
Particulars Present Capital Proposed Capital Structure Rs 1,00,000
Structure Share
All Equity Equity + Equity + Rs. 10 each
(All Equity)
Pref. Share Debenture
EBIT 40,000 40,000 40,000 40,000
5,000 equity share
(Less: Interest) - - - 5000 for Rs. 10 each
PBT 40,000 40,000 40,000 35,000
(Less: Tax) 20,000 20,000 20,000 17,500
5,000 preference
PAT 20,000 20,000 20,000 17,500 share at 12% for
(Less: Pref. Dividend) - - 6,000 - Rs 10 each
Profit for Equity Shareholders 20,000 20,000 14,000 17,500
No. of Equity Share 10,000 15,000 10,000 10,000
Issue of 10%
EPS 2 1.33 1.4 1.75 debenture of Rs.
Dilution against initial EPS 2 0.67 .6 0.25 50,000
 Calculation of Earning Per Share when EBIT
increased 10,000
PRESENT AND PROJECTED EARNING PER SHARE
Particulars Present Capital Proposed Capital Structure
Structure 5,000 equity share
All Equity Equity + Equity + for Rs. 10 each
(All Equity)
Pref. Share Debenture
EBIT 40,000 50,000 50,000 50,000
(Less: Interest) - - - 5000
PBT 40,000 50,000 50,000 45,000
5,000 preference
(Less: Tax) 20,000 25,000 25,000 22,500 share at 12% for
Rs 10 each
PAT 20,000 25,000 25,000 22,500
(Less: Pref. Dividend) - - 6,000 -
Profit for Equity Shareholders 20,000 25,000 19,000 22,500
No. of Equity Share 10,000 15,000 10,000 10,000 Issue of 10%
debenture of Rs.
EPS 2 1.67 1.9 2.25 50,000
Dilution against initial EPS 2 - 0.33 - 0.10 +0.25
Thank You