Capital Structure Decisions in Financial Management

CAPITAL STRUCTURE
DECISIONS IN FINANCIAL
MANAGEMENT
Dr. T.K. Jain.
AFTERSCHO☺OL
Centre for social entrepreneurship
Bikaner M: 9414430763
tkjainbkn@yahoo.co.in
www.afterschool.tk, www.afterschoool.tk
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What is leveraging?
• When a firm uses fixed cost sources of
funds, it is called leveraging. Higher the
ratio of debt in total funds, higher the
leveraging.
• Unleveraged firm is that which has no
debt.

If there are two companies, one
with leverage of 1 and other with
leverage of 20 ,which one will you
select for investments (you are risk
averse investor)?
• First company.

Solution
• There are 2 ways to find leverage:
• Operating leverage = contribution / EBIT
• Contribution = Sales – Variable cost
• =50,00,000 – 20,00,000 = 30,00,000
• EBIT = 30,00,000 – 25,00,000 = 5 lakhs
• Operating leverage = 30 lakhs/ 5 lakhs
• Thus operating leverage is 6 times. Ans.

A Company produces and sells
10,000 shirts. The selling price per
shirt is Rs.
500. Variable cost is Rs. 200 per
shirt and fixed operating cost is Rs.
25,00,000.
(a) Calculate operating leverage.
(b) If sales are up by 10%, then
what is the impact on EBIT?

What will happen if sales are up by
10%, then what is the impact on
EBIT?
• Operating leverage = %change in EBIT /
% change in sales
• New EBIT = 55,00,000 – (22,00,000 +
25,00,000) = 8 lakhs
• Change = 3 lakhs or 3/5*100 = 60%
change
• Operating leverage = 60%/10% = 6 times.
Answer.
Suppose there are 2 firms with the same
operating leverage, business risk and
probability of EBIT and only differ with respect
to their use of debt.
• Goti International • Ramesh

• No Debt Continental
• $20000 in assets • $10000 debt at
• 40% tax 12%
• $20000 in assets
• 40% tax

In the previous statement, if EBIT is
between $ 2000 to 4000 with equal
probability, what are the
possibilities?
• Suppose income is • Suppose income is
2000$ 2000$ - int.1200
• EAT = 1200 • EAT = 480
• 3000 is EBIT • 3000 is EBIT -
• EAT = 1800 1200
• EBIT is 4000 • EAT = 1080
• EAT = 2400 • EBIT is 4000 -
www.afterschoool.tk 1200
AFTERSCHO☺OL's MATERIAL
Analysis
• BEP = EBIT / Total assets.
• 2000/20000
• =.1
• ROE= PAT/NETWORTH
PAT/NETWORTH
• =1200/20000=.06
=480/10000=.048
• DSCR / ICR
• =EBIT / INT
• =2000/1200=1.67

APPLYING PROBABILITY
• Suppose probability of EBIT of
2000,3000,4000 is .25, .5 and .25.
• Thus we have to find expected BEP, ROE
and DSCR / ICR for the two firms.

EXPECTED VALUES OF
BEP,ROE,DSCR
• Ramesh
Goti
• BEP =.25*.1 +.5*.15 +.25*.2 = .15
• ROE=.25*.06 +.5*.09
ROE=.25*.048 +.5*.108+.25*.168
+.25*.12 = .09
= .108
• DSCR= NO LOAN+.5*.025+.25*.033 =.024
DSCR=.25*.0167

Jitu Global Productions has
following details:
• Sales $ 24,00,000 (@$100)
• Variable cost = 50%
• Fixed cost = $10,00,000
• Borrowing = $10,00,000 @10%
• Equity 10,00,000 (face value $100)
• Find its combined leverage?

Solution
• EBIT = 2400000 – (1200000+1000000)
• Operating leverage
• Contribution / EBIT
• 1200000/200000=6
• Financial leverage
• EBIT / (EBIT – Interest)
• =200000/(200000-100000) = 2
• Combined leverage = 6*2 = 12 answer.

Find the combined leverage
installed Capacity 4000 units

Actual Production and Sales 75%
Selling Price 30 per unit
Variable Cost 15 per unit
Fixed Cost:
Under Situation I 15000
Under Situation-il 20000
Financial Plan
A B
Equity 10,000 15,000

Debt (20%) 10,000 5,000
Total 20,000 20,000

Solution – operating leverage in
plan A and plan B.
• Sales : 3000*30 = 90000
• Contribution
• 90000-45000=45000
• EBIT = 90000-(45000+20000)
90000-(45000+15000)
• =30000
=25000
• Operating leverage=1.8
leverage=1.5

Solution – Financial leverage in
plan A and plan B.
• EBIT /=25000
(Ebit-interest)
• EBIT =30000= 1.04
25000/24000
• 30000/28000 = 1.07
• Combined leverage
• =1.5*1.07=1.605
=1.8*1.04=1.87

Question on NI approach
• Rupa Company’s EBIT is Rs. 5,00,000.
The company has 10% 20 lakh
debentures. The equity capitalization rate
i.e. Ke is 16%.
• You are required to calculate:
• (i) Market value of equity and value of firm
• (ii) Overall cost of capital

Solution
• Market value of the firm = Value of equity (
market value) + value of debt.
• Value of equity = [EBIT – Interest (1-ts)]/K

• (there is an assumption that there are no
taxes in all the theories of capital
structure)
• =500000 – 200000 = 300000
Solution …
• Equity = 3 lakh / .16
• =1875000
• Debt = 20,00,000
• Total value = 38,75,000
• Answer.

Ramesh Ltd’s. operating income is $ 5,00,000.
The firms cost of debt is 10%
firm employs $ 15,00,000 of debt. The overall
cost of capital of the firm is
15%. What is total value of the firm.
& Cost of equity as per NOI approach.
• In NOI approach, we take up operating income

and capital structure decision is immaterial (not
relevant). Cost of equity depends on ratio of
debt (higher the debt, higher the cost of equity).
Solution
• Value of firm = 500000/ .15
• =33,33,333
• Value of debt = 1500000
• Thus value of equity = 18,33,333
• Earnings available to equity share holders:
• 500000 – 150000 = 350000 (we assume no
taxes)
• Cost of equity = 3,50,000/18,33,333 *100 =
19.09% answer.
There are two firms – Goti
International & Ramesh Global.
Goti International is leveraged
company having debt of $ 100,000
@ 7%. Cost of equity of both the
companies is 11.5% and 10%
respectively.analyse using MM
approach. EBIT = $20000
• As you can see that the overall value of
the firm is same – so no impact of debt.
Analysis
• Ramesh
Goti
• Debt = 100000
EBIT 20000
• EAI = 20000-7000
Equity = 20000/.1
• =13000 (we assume no taxes)
=200000
• Equity
• =13000/.115
Thus we can see that the value of Goti International is
• little
=113043bit higher
• Total value
• =2,13,043

Arbitrage process
• You may invest
you borrowin(take
Goti personal
International
leverage) and invest in
• Ramesh
Suppose –webecause it it unleveraged
invest 10000, firm
we get = 1150
• Here we can borrow 10000 and invest our own 10000.
We get 2000 as return, and we have to pay interest of
700, so finally we have 1300 left out.

Vinod Bhugari Continental has
EBIT of $ 100000. Company has
10% debentures of $ 5 Lakhs and
equity capitalisation rate is 15%.
What is the value of the firm as per
traditional approach ?
• Earnings after interest = 100000-50000
• =50000 (we ignore taxes)
• Value of equity = 50000/.15 = 333333
• Value of the firm=$ 833333 answer.
Sarika Consultants & Pankaj Baid
Consultants are two firms. Having
NOI of $ 15 lakhs each.Pankaj Baid
consultants have taken ECB of $7
lakhs @11%. Tax rate = 33%
Equity of Sarika consultants $ 13
lakhs and that of Pankaj
Consultants is $6 lakhs

Solution
• Pankaj Consultants
Sarika Consultants
• EBIT = 1.5 million
• Tax = 5 Lakhs
Interest = 77000
• EAT = 1 14,23,000
EAIBT= million
• Cost of
Tax= 4,74,333
equity
• 10/13=*100
EAT 9,48,666
= 77%
• Valueof
Cost = equity
13 lakhs
=
• 948666/600000*100 =158%
• Value of firm 13 laks

In the previous question, what will
happen if cost of equity is given as
20% in both the cases?
• Sarika Consultants • Pankaj Consultants
• EBIT = 1.5 million • EBIT = 1.5 million
• Tax = 5 Lakhs • Interest = 77000
• EAT = 1 million • EAIBT= 14,23,000
• Value of equity • Tax= 4,74,333
• =10,00,000/.2 • EAT = 9,48,666
• =50,00,000 • Value of equity
• Total value of the firm is • =948666/.2 =47,43,330
also 50 lakhs
• Total value of the firm
• =54,43,330 answer.
In the previous question, what will
happen, if market capitalises operting
income as a whole @ 20%?
• Sarika Consultants • Pankaj Consultants
• EBIT = 1.5 million • EBIT = 1.5 million
• Tax = 5 Lakhs • Interest = 77000
• EAT = 1 million • EAIBT= 14,23,000
• Value of the firm • Tax= 4,74,333
• =10 lakhs / .2 • EAT = 9,48,666
• = 50 lakhs • Value of the firm
• Value of equity = 50
lakhs
• 1500000/.2 = 7500000
• Cost of equity = 20% • Value of equity =
6800000
• Cost of equity
• 13.94%
Operating leverage…
• = % change in EBIT / % change in sales
• Actually it measures the impact of fixed
cost (as aginst variable cost).

Financial leverage…
• % change in EPS / % change in EBIT
• Actually it measures the impact of interest
and other such fixed charge securities on
EPS.
• EPS = earning per share.

Alternate formulaes
• Operating leverage
• = Contribution / EBIT
• Financial leverage
• = EBIT / (EBIT – interest)

What is capital structure?
• Combination of capital is called capital
structure. The firm may use only equity, or
only debt, or a combination of equity +
debt, or a combination of
equity+debt+preference shares or may
use other similar combinations.

How do you design capital
structure?
1. It should minimise cost of capital
2. It should reduce risks
3. It should give required flexibility
4. It should provide required control to the
owners
5. It should enable the company to have
adequate finance.

What are the risks associated with
capital structure decisions?
• Meaning of risk = variability in income is
called risk.
• Business risk = it is the situation, when the
EBIT may vary due to change in capital
structure. It is influenced by the ratio of fixed
cost in total cost. If the ratio of fixed cost is
higher, business risk is higher.
• Financial risk = it is the variability in EPS due
to change in capital structure. It is caused
due to leverage. If leverage is more,
variability will be more and thus financial risk
will be more.
Degree of financial leverage?
• It shows the extend of financial risk.
Higher the DFL, higher is the financial risk.
• Formula =
• % change in EPS / % change in EBIT.
• Suppose EBIT changes 10%, due to this
EPS changes 20%,
• 20/10 = 2
• DFL is 2.
EBIT - EPS analysis
• Generally cost of debt is lower than cost of
equity. Therefore raising debt (trading on
equity) increases EPS and it gives benefit
to the shareholders. However, excess of
debt will create more risk and therefore it
is not advisable. A firm can identify an
ideal level of quantum of debt and equity
so that it is within proportion.

Formula
• [(EBIT – I1) (1-t)]/ E1 = [(EBIT – I2) (1-t)]/
E2
• E1 = equity in 1st alternative (no debt or
minimum debt)
• E2 = equity in 2nd alternative (no debt or
max. debt)
• I1 and I2 represent interest payable in the
2 alternatives respectively.
What do you understand from
trading on equity?
• With capital, we can raise debt, and raise
our EPS, this is called trading on equity.

What is coverage ratio or DSCR?
• DSCR = debt service coverage ratio
• Coverage ratio denotes the extent to which
interest is covered by the EBIT. It denotes
whether we have sufficient earnings to meet
our interest obligation. If DSCR is 1 or less
than one, it is dangerous situation.
• Formula = EBIT / interest.
• Higher the DSCR, less is the risk (because
there is higher coverage).

Theory of optimal capital structure?
• This theory states that we can have an
optimum capital structure – as we raise the
debt, we can raise the value of the firm to
some extent. Thus level of debt can be
increased upto some level. That level is the
ideal capital structure.
• Ultimate objective of Finance manager is to
raise the value of the firm and raise the
wealth – which is possible by an ideal capital
structure.
Is there indifference point?

Solve the following
• Goti continental Inc. a profit makipg company, has a paid-
up capital of Rs. 100 lakhs consisting of 10 lakhs ordinary
shares of Rs. 10 each. Currently, it is earning an annual
pre-tax profit of Rs. 60 lakhs. The company’s shares are
listed and are quoted in the range of Rs. 50 to Rs. 80. The
management wants to diversify production and has
approved a project which will cost Rs. 50 lakhs and which
is expected to yield a pre-tax income of Rs. 40 lakhs per
annum. To raise this additional capital, the following
options are under consideration of the management:
• (a) To issue equity capital for the entire additional
amount. It is expected that the new shares (face value of
Rs. 10) can be sold at a premium of Rs. 15.
• (b) To issue 16% non-convertible debentures of Rs. 100
each for the entire amount. Tax rate = 30%

Solution
• (a) raising additional equity – how much
equity required?
• One share will give you 10 + 15 = 25
• Capital required = 50 lakhs.
• 50/25 = 2 lakh shares. (we already have
10 lakh shares)

Solution
• (B) All
(a) All equity
debt :
• Earnings = 60 + 40 = 100
• Tax: 30 of interest:
Payment
• EAT =of70
16% Rs. 50 lakhs =8 lakhs
• No. of shareholders:
EAIBT = 92 12 lakh shares
• EPS 30%
Tax: = 70 =/ 12=5.83
27.6
• EAT = 64.4
• No. of shareholders: 10 lakh shares
• EPS = 64.4 / 10=6.44

Analysis
• From the above analysis, it is clear that
EPS is higher in the case when we are
raising debt. (therefore this option is better
and the firm should go for raising debt).
• We also have to look at the overall market
capitalisation and overall value of the firm.
• Suppose, PE ratio of the industry is 20, the
value of the firm is as under:

Solution
• Debt
(a) all equity
• 5.83 of
Use *20debt
= 116.6
will reduce the PE ratio to some extent as
• Beta willitincrease.
Multiply However, let us calculate using 20 as
with 12 lakhs,
• PE
Theratio:
value of the firm is 1399.2 lakhs. Thus from this
• 20*6.44
analysis, =this
128.8 *10islakhs
option + 16 lakhs
better.
• =1304 lakhs

Theories of capital structures . .
• There are 4 theories:
1. NI approach (net income approach)
2. NOI approach (net operating income
approach)
3. MM approach (Modigliani Millar
Approach)
4. Traditional approach

Assumptions in capital structure
theories …..
1. There are only 2 sources of finance –
debt and equity
2. Taxes are ignored
3. Dividend payout ratio is 100%
4. Business risk is constant
5. Firm’s total financing remains constant.

NI approach (net income approach)
• When you raise debt, leverage will increase. The
overall value of the firm will incrase. Debt will
have lower cost, so overall cost of capital will
reduce (it is better if the cost of capital reduces).
• V = S+ D
• V = value of the firm, S = equity, D = debt
• An increase in leverage will increase the value
of the firm, it will raise EPS, it will raise the
market price of the shares and it will reduce
weighted average cost of capital, thus leverage
is always beneficial.

NOI approach (Net operating
income approach)
• Capital structure decision is irrelevant. If
you raise debt, the cost of equity will
increase. The overall cost of capital will
remain constant in spite of leverage. Thus
there is no advantage of raising debt. As
we raise the debt, the cost of equity
increases in the same proportion. The
market discounts the firm, which is
leveraged. Thus capital structure decision
has no relevance.
MM approach
• It is similar to NOI approch


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CAPITAL STRUCTURE

www.afterschoool.tk AFTERSCHO☺OL's MATERIAL

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• Goti International • Ramesh

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installed Capacity 4000 units

Equity 10,000 15,000

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• Value of equity = [EBIT – Interest (1-ts)]/K

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• In NOI approach, we take up operating income

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