This document discusses various approaches to determining an appropriate capital structure for a business, including the EBIT-EPS approach, valuation approaches using cost of capital and adjusted present value, and cash flow approaches. It provides details on calculating EBIT, EPS, leverage (operating, financial, and combined), and determining the optimal capital structure. Key points covered include the EBIT-EPS analysis method, calculating financial break-even points and indifference points, and applying the adjusted present value valuation approach.

1. THE BUSINESS SCHOOL
UNIVERSITY OF JAMMU
REPORT ON - “APPROACHES TO APPROPRIATE CAPITAL
STRUCTURE WITH ONE FOCUS ON EBIT – EBS CONCEPT , COST OF CAPITAL &
VALUATION APPROACH , CASH FLOW APPROACH ”
SUBMITTED BY:
RADHIKA GUPTA
ROLL NO – 32- Mba -14

2. C APITAL STRUCTURE:
• The term capital structure is used to represent the proportionate relationship between
debt, preference and equity shares on a firm’s balance sheet.
• The various means of financing represent the financial structure of an enterprise. The left-
hand side of the balance sheet (liabilities plus equity) represents the financial structure of
a company. Traditionally, short-term borrowings are excluded from the list of methods of
financing the firm’s capital expenditure
• Capital structure refers to a business's balance of debt and equity financing. Businesses
have two options for financing the purchases of equipment, expenses and materials
necessary for their operations. They can raise money from investors, which is equity
financing, or they can borrow from banks and creditors -- leverage or debt financing.
Most businesses engage in a degree of both, paying careful attention to the costs
associated with either source. Relying too heavily on equity increases the cost to
investors and cuts into return. But relying too much on debt puts the business in a more
precarious position and comes with the substantial costs of interest.
QUESTIONS WHILE MAKING THE FINANCING DECISION:
• How should the investment project be financed?
• Does the way in which the investment projects are financed matter?
• How does financing affect the shareholders’ risk, return and value?
• Does there exist an optimum financing mix in terms of the maximum value to the firm’s
shareholders?
• Can the optimum financing mix be determined in practice for a company?
• What factors in practice should a company consider in designing its financing policy?
OPTIMUM CAPITAL STRUCTURE:

3. Optimum capital structure is the capital structure at which the market value per share is
maximum and the cost of capital is minimum.
APPROACHES TO DETERMINEAPPROPRIATE CAPITAL
STRUCTURE:
1) EBI T – EPS APPROACH–
This approach is helpful to analyze the impact of debt on EARNINGS PER SHARE.
The EBIT-EPS approach can help balance a company's debt with its equity.
Effective business management requires careful planning and decision-making about the balance
of debt and equity used in financing the business. The EBIT-EPS approach is one method
available to managers to guide them in making decisions about capital structure. To benefit from
the EBIT-EPS approach, it helps to understand the basics of how it works, as well as its
advantages and drawbacks.
The EBIT-EPS approach is one tool managers use to decide on the right mix of debt and equity
financing in a business's capital structure. In the EBIT-EPS approach, the business plots graphs
of its performance at different possible debt-to-equity ratios, such as 40 percent debt to 60
percent equity. In a basic graph, the earnings per share as a data point is plotted for each level of
earnings before interest and taxes at different debt-to-equity ratios. The graph is then analyzed to
determine the ideal level of debt-to-equity for the business.
EBIT/EPS ANALYSIS:
EBIT-EPS analysis is an approach which helps in designing the optimum capital structure for
the company or the firm
To design various alternatives of debt, equity and preference shares in order to maximize the
EPS at a given level of EBIT.
It examines how different capital structures affect earnings available to shareholders (Earning
Per Share).

4. It is the analysis of the effect of financing alternatives on earnings per share.
To design the capital structure of the firm in such a way so as to minimize the cost of capital.
EBIT-EPS analysis is a method to study the effect of leverage under alternative methods of
financing.
The EPS-EBIT approach to capital structure involves selecting the capital structure that
maximizes EPS over the expected range of EBIT.
Using this approach, the emphasis is on maximizing the owners returns (EPS).
A major shortcoming of this approach is the fact that earnings are only one of the determinants
of shareholder wealth maximization.
This method does not explicitly consider the impact of risk.
EPS-EBIT Approach to Capital Structure:
Example
EBIT-EPS coordinates can be found by assuming specific EBIT values and calculating the EPS
associated with them. Such calculations for three capital structures—debt ratios of 0%, 30%,
and 60%—for Cooke Company were presented earlier in Table 12.2. For EBIT values of
$100,000 and $200,000, the associated EPS values calculated are summarized in the table

5. CALCULATION OF EBIT:
CALCULATION OF EPS:

6. Analysis for Risk and Return
Once the relationship between EBIT and EPS is plotted for different capital structures, the
investor can analyze the graph, focusing on two key challenges. The level of EBIT where EPS is
zero, called the break-even point, and the graph's slope, which visually represents the company's
risk. A steeper slope conveys a higher risk -- greater loss per share at at lower EBIT level. A
steeper slope also means a higher return, and that the company needs to earn less EBIT to
produce greater EPS. The breakeven point is also important because it tells the business how
much EBIT there must be to avoid losses, and varies at different proportions of debt to equity.
Drawbacks
The EBIT-EPS approach is not always the best tool for making decisions about capital
structuring. The EBIT-EPS approach places heavy emphasis on maximizing earnings per share
rather than controlling costs and limiting risk. It's important to keep in mind that as debt
financing increases, investors should expect a higher return to account for the greater risk; this is
known as a risk premium. The EBIT-EPS approach does not factor this risk premium into the
cost of financing, which can have the effect of making a higher level of debt seem more
advantageous for investors than it actually is.
LEVERAGE:
Leverage is the employment of an asset/source of finance for which firm pay fixed cost/fixed
return. It may of three types:
1) Operating Leverage - Operating leverage is caused due to fixed operating expenses in the
firm. It may be defined as the firm’s ability to use fixed operating costs to magnify the
effects of changes in sales on its earnings before interest and taxes. Operating leverage is
associated with investment (assets acquisition) activities.

7. A firm sells products for Rs. 100 per unit, has variable operating cost of Rs. 50 per unit and
fixed operating cost of Rs. 50000 per year. Show the various levels of EBIT that would
results from the sale of (i) 1000 units, (ii) 2000 units and (iii) 3000 units.
How to calculate OL?
The degree of operating leverage may be defined as the change in the percentage of operating
income (EBIT), for the change in percentage of sales revenue. The degree of operating leverage
at any level of output is arrived at by dividing the percentage change in EBIT with percentage
change in sales. That is
Degree of Operating Leverage (DOL) = Percentage change in EBIT / Percentage change in
sales
Or
DOL=Contribution / Operating profit (EBIT)
Impact of OL:
Operating leverage may be favorable or unfavorable. High degree of operating leverage
indicates that high degree of risk. It is good when revenues are rising and bad when they are
falling.
Operating risk (business risk) is the risk of the firm not being able to cover its fixed
operating costs. The larger the magnitude, the larger the volume of sales required to cover all
fixed costs.
Application of Operating Leverage
 It is helpful to know how operating profit (EBIT) would change with a given change in
units produced.
 It will helpful in measuring business risk.
2) Financial Leverage - Financial leverage is the ability of the firm to use fixed financial
charges to magnify the effects of changes in EBIT on the firm’s earnings per share.

8. In other words, financial leverage may be defined as the payment of fixed rate of interest
for the use of fixed interest bearing securities to magnify the rate of return on equity
shares
• The financial manager of the Hypothetical Ltd. expects that its EBIT in the current year
would amount to Rs. 10000. The firm has 5 per cent bonds aggregating Rs. 40000, while
the 10 percent preference shares amount to Rs. 20000. what would be the earning per
share ? Assuming the EBIT being (i) Rs. 6000, and (ii) Rs. 14000, how would he EPS be
affected. The firm can be assumed to be in the 35 percent tax bracket. The no. of
outstanding shares is 1000.
Financial leverage in computed by the following formula:
Degree of financial leverage (DFL)= Percentage change in EPS divided by Percentage
change in EBIT:
Impact of FL:
• Financial leverage may be positive or negative. favorable leverage occurs when the firm
earns more on the assets purchased with the funds, than the fixed cost of their use and
vice versa. Higher the degree of financial leverage leads to high financial risk.
• The financial risk refers to the risk of the firm not being able to cover its fixed financial
costs. Hence, financial manager should take into consideration the level of EBIT and
fixed charges while preparing the firm’s financial plan.
EBIT-EPS analysis
t
Dp
IEBIT
EBIT
FL



1

9. Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to
Rs. 1000000. the firm now wishes to raise additional Rs. 10 lac for expansion. The firm has four
alternative financial plans:
1. It can raise the entire amount in the form of equity capital.
2. It can raise 50 percent as equity capital and 50 percent as 5% debentures.
3. It can raise the entire amount as 6% debentures.
4. It can raise as 50 percent as equity capital and 50 % as preference capital.
Further assume that the existing EBIT are Rs. 120000, the tax rate is 35 percent, outstanding
ordinary shares 10000 and the market price per share is Rs. 100 under all the four alternatives.
What financing plan should the firm accept?
Financial break evenpoint
It is the level of EBIT that a firm must earn to pay its fixed financial charges.
Financial BEP= Interest + Dp /(1-t)
 The EBIT level at which the EPS is the same for two alternative financial plan is referred
to as the indifference point/level.
 Financial break even point obtained by a company at a given level of EBIT for which the
firm’s EPS is zero.
 If EBIT is less than financial break even point, then the EPS is negative.
 If EBIT is more than the financial break even point, then more and more fixed cost
financing option can be used by a firm.
Indifference point:
It is the EBIT level at which the EPS is same for two alternative financial plans. It is beyond this
point only, the benefits of financial leverage accrues with respect to EPS.

10. The financial manager of a company has formulated following financial plans to finance Rs. 30
lac required to implement various capital budgeting projects:
(i) Either equity capital of Rs. 30 lac or Rs. 15lac 10% debenture and Rs. 15 Lac equity.
You are required to determine the indifference point for each financial plan , assuming 35 per
cent corporate tax rate and the face value of equity shares as Rs. 100.
3) Combined Leverage:
The degree of combined leverage may be defined as the percentage change in EPS due to the
percentage change in sales.
Thus the combined leverage is:
Impact of CL:
• The combined leverage can work in both directions. It is favorable if sales increase and
unfavorable when sales decrease.
• This is because the change in sales results in more than proportion returns in the form of
EPS. Financial leverage and operating leverage are something like double-edged sword.
salesChange%
EPSinchange%
EBITinChange%
EPSinChange%
*
salesinchange%
EBITinChange%
CL

11. • They have tremendous acceleration or deceleration effects on EBIT and EPS. A right
combination of these leverage is blessing for corporate growth, while an improper
combination may prove as a curse.
2) VALUATION APPROACH–
This approach determines the impact of debt use on the share holders value
Firm Valuation: Cost of Capital and Adjusted Present Value Approaches
The two approaches to valuing the equity in the firm—the dividend discount model and the free
cash flow to equity (FCFE) valuation model. This approaches to valuation in which the entire
firm is valued, by either discounting the cumulated cash flows to all claim holders in the firm by
the weighted average cost of capital (the cost of capital approach) or by adding the marginal
impact of debt on value to the unlevered firm value—the adjusted present value (APV) approach.
In the process of looking at firm valuation, we also look at how leverage may or may not affect
firm value. We note that in the presence of default risk, taxes, and agency costs, increasing
leverage can sometimes increase firm value and sometimes decrease it. In fact, we argue that the
optimal financing mix for a firm is the one that maximizes firm value.
FREE CASH FLOW TO THE FIRM :
The free cash flow to the firm (FCFF) is the sum of the cash flows to all claim holders in the
firm, including common stockholders, bondholders, and preferred stockholders. There are two
ways of measuring the free cash flow to the firm.
One is to add up the cash flows to the claim holders, which would include cash flows to equity
(defined either as free cash flow to equity or as dividends); cash flows to lenders (which would
include principal payments, interest expenses, and new debt issues); and cash flows
Adjusted present value

12. Adjusted Present Value (APV) is a business valuation method. APV is the net present value of
a project if financed solely by ownership equity plus the present value of all the benefits of
financing. It was first studied by Stewart Myers, a professor at the MIT Sloan School of
Management and later theorized by Lorenzo Peccati, professor at the Bocconi University, in
1973.
The method is to calculate the NPV of the project as if it is all-equity financed (so called base
case). Then the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit
is a tax shield resulted from tax deductibility of interest payments. Another benefit can be a
subsidized borrowing at sub-market rates. The APV method is especially effective when a
leveraged buyout case is considered since the company is loaded with an extreme amount of
debt, so the tax shield is substantial.
Technically, an APV valuation model looks similar to a standard DCF model. However, instead
of WACC, cash flows would be discounted at the unlevered cost of equity, and tax shields at
either the cost of debt (Myers) or following later academics also with the unlevered cost of
equity . APV and the standard DCF approaches should give the identical result if the capital
structure remains stable.
APV formula
APV = Unlevered NPV of Free Cash Flows and assumed Terminal Value + NPV of Interest Tax
Shield and assumed Terminal Value
The discount rate used in the first part is the return on assets or return on equity if unlevered. The
discount rate used in the second part is the cost of debt financing by period.
In detail:
EBIT- Taxes on EBIT
=Net Operating Profit After Tax (NOPAT)

13. + Non cash items in EBIT- Working Capital changes - Capital Expenditures and Other
Operating Investments
=Free Cash Flows
Take Present Value (PV) of FCFs discounted by Return on Assets % (also Return on
Unlevered Equity %)+ PV of terminal value
=Value of Unlevered Assets
+ Excess cash and other assets
=Value of Unlevered Firm (i.e. firm value without financing effects or benefit of interest
tax shield)
+ Present Value of Debt's Periodic Interest Tax Shield discounted by Cost of Debt
Financing %
=Value of Levered Firm
- Value of Debt
=Value of Levered Equity or APV
Valuation Methods – The Asset Approach:
Business valuation approaches
That said, there are four fundamental ways to measure what a business is worth:
 Asset Approach
 Market Approach
 Income Approach
 Earnings Based Approach

14. 1) Asset approach
The asset approach views the business as a set of assets and liabilities that are used as building
blocks to construct the picture of business value. The asset approach is based on the so-called
economic principle of substitution which addresses this question:
What will it cost to create another business like this one that will produce the same
economic benefits for its owners?
Since every operating business has assets and liabilities, a natural way to address this question is
to determine the value of these assets and liabilities. The difference is the business value.
Sounds simple enough, but the challenge is in the details: figuring out what assets and liabilities
to include in the valuation, choosing a standard of measuring their value, and then actually
determining what each asset and liability is worth.
For example, many business balance sheets may not include the most important business assets
such as internally developed products and proprietary ways of doing business. If the business
owner did not pay for them, they don't get recorded on the "cost-basis" balance sheet!
But the real value of such assets may be far greater than all the "recorded" assets combined.
Imagine a business without its special products or services that make it unique and bring
customers in the door!
The asset approach is one of the approaches used to estimate enterprise and equity value, and is
used in IRC 409A valuations. The asset approach is defined in the International Glossary of
Business Valuation Terms as “a general way of determining a value indication of a business,
business ownership interest, or security using one or more methods based on the value of the
assets net of liabilities.” The approach uses the books of the company to identify the fair value
of the assets, both tangible and intangible, and the liabilities to determine a net value for the
company. Whereas the market and income approaches both focus on income statement activity,
the asset approach primarily utilizes the company’s balance sheet. The asset approach is often

15. utilized when a company is no longer operating as a going concern and is preparing for
liquidation. Other times the asset approach can be used is when the business is based on assets,
such as an investment vehicle, and not on income, such as a production company.
For businesses whose income is derived primarily from its assets, the asset-based valuation is
most appropriate. The main characteristics of this particular valuation are:
 Company’s balance sheet items are valued at current market value and intangible assets
are added.
 Factors that affect a company’s value either favorably or unfavorably are considered and
compensatory adjustments are made.
2) Market approach
The market approach, as the name implies, relies on signs from the real market place to
determine what a business is worth. Here, the so-called economic principle of competition
applies:
What are other businesses worth that are similar to my business?
No business operates in a vacuum. If what you do is really great then chances are there are others
doing the same or similar things. If you are looking to buy a business, you decide what type of
business you are interested in and then look around to see what the "going rate" is for businesses
of this type.
If you are planning to sell your business, you will check the market to see what similar
businesses sell for.
It is intuitive to think that the "market" will settle to some idea of business price equilibrium -
something that the buyers will be willing to pay and the sellers willing to accept. That's what is
known as the fair market value:

16. The business price that a willing buyer will pay, and a willing seller will accept for the business.
Both parties are assumed to act in full knowledge of all the relevant facts, and neither being
under compulsion to conclude the sale.
So the market approach to valuing a business is a great way to determine its fair market value - a
monetary value likely to be exchanged in an arms-length transaction, when the buyer and seller
act in their best interest. Market data is great if you need to support your offer or asking price -
after all, if the "going rate" is this much, why would you offer more or accept less?
Market-Based valuations focus mainly on comparative company data from both the public and
private sector within the same or similar industry.
For this type of valuation, it is essential that the appraiser have the appropriate industry resources
and is fully appraised of current statistics relating to similar businesses.
3) Income approach
The income approach takes a look at the core reason for running a business - making money.
Here the so-called economic principle of expectation applies:
If I invest time, money and effort into business ownership, what economic benefits and
when will it provide me?
Notice the future expectation of economic benefit in the above sentence. Since the money is not
in the bank yet, there is some measure of risk - of not receiving all or part of it when you expect
it. So, in addition to figuring out what kind of money the business is likely to bring, the income
valuation approach also factors in the risk.
Since the business value must be established in the present, the expected income and risk must
be translated to today. The income approach uses two ways to do this translation:
 Capitalization

17.  Discounting
Business valuation by direct capitalization
In its simplest form, the capitalization method basically divides the business expected earnings
by the so-called capitalization rate. The idea is that the business value is defined by the business
earnings and the capitalization rate is used to relate the two.
For example, if the capitalization rate is 33%, then the business is worth about 3 times its annual
earnings. An alternative is a capitalization factor that is used to multiply the income. Either way,
the result is what the business value is today.
Valuation of a business by discounting its cash flows
The discounting method works a bit differently: first, you project the business income stream
over some future period of time, usually measured in years. Next, you determine the discount
rate which reflects the risk of getting this income on time.
Last, you figure out what the business will be worth at the end of the projection period. This is
called the residual or terminal business value. Finally, the discounting calculation gives you the
so-called present value of the business, or what it is worth today.
4) Earnings BasedApproach
This method determines the value of a business based on its anticipated future earnings. Newly
formed businesses, companies involved in dynamic industries, and companies that are service-
intensive are most appropriate for this form of valuation.
Two main procedures are utilized to determine future value:
 Earnings are projected over a five to ten year period and then adjusted to determine
present value.
 Unusual factors are eliminated in a review of past financial data. The normalized results
are capitalized to determine value.

18. 3)CashFlow Approach –
This approach analyses the firm’s debt service capacity .
'Free Cash Flow To Equity - FCFE'
This is a measure of how much cash can be paid to the equity shareholders of the company after
all expenses, reinvestment and debt repayment.
Calculated as: FCFE = Net Income - Net Capital Expenditure - Change in Net Working
Capital + New Debt - Debt Repayment
FCFE is often used by analysts in an attempt to determine the value of a company.
This alternative method of valuation gained popularity as the dividend discount model's
usefulness became increasingly questionable.
In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be
distributed to the equity shareholders of the company as dividends or stock buybacks—after all
expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash
flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders.
The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is
also called the levered free cash flow.
Basic formulae
Assuming there is no preferred stock outstanding:
where:
 FCFF is the free cash flow to firm;

19.  Net Borrowing is the difference between debt principals paid and raised;
 Interest*(1-t) is the firm's after-tax interest expense.
or
where:
 NI is the firm's net income;
 D&A is the depreciation and amortisation;
 Capex is the capital expenditure;
 ΔWC is the change in working capital;
 Net Borrowing is the difference between debt principals paid and raised;
 In this case, it is important not to include interest expense, as this is already figured into
net income.
FCFF vs. FCFE
 Free cash flow to firm (FCFF) is the cash flow available to all the firm’s providers of
capital once the firm pays all operating expenses (including taxes) and expenditures
needed to support the firm’s productive capacity. The providers of capital include
common stockholders, bondholders, preferred stockholders, and other claimholders.
 Free cash flow to equity (FCFE) is the cash flow available to the firm’s common
stockholders only.
 If the firm is all-equity financed, its FCFF is equal to FCFE.
Negative FCFE
Like FCFF, the free cash flow to equity can be negative. If FCFE is negative, it is a sign that the
firm will need to raise or earn new equity, not necessarily immediately. Some examples include:
 Large negative net income may result in the negative FCFE;

20.  Reinvestment needs, such as large capex, may overwhelm net income, which is often the
case for growth companies, especially early in the life cycle.
 Large debt repayments coming due that have to be funded with equity cash flows can
cause negative FCFE; highly levered firms that are trying to bring their debt ratios down
can go through years of negative FCFE.
 The waves of the reinvestment process, when firms invest large amounts of cash in some
years and nothing in others, can cause the FCFE to be negative in the big reinvestment
years and positive in others;[4]
 FCFF is a preferred metric for valuation when FCFE is negative or when the firm's
capital structure is unstable.
Use
There are two ways to estimate the equity value using free cash flows.
 Discounting free cash flows to firm (FCFF) at the weighted average cost of capital
(WACC) yields the enterprise value. The firm’s net debt and the value of other claims are
then subtracted from EV to calculate the equity value.
 If only the free cash flows to equity (FCFE) are discounted, then the relevant discount
rate should be the required return on equity. This provides a more direct way of
estimating equity value.
 In theory, both approaches should yield the same equity value if the inputs are consistent.