1. Capital Structure

2. Meaning of Capital Structure
• Capital structure is the combination of capitals from different sources
of finance
• The capital of a company consists of equity share holders’ fund, preference
share capital and long term external debts
• The source and quantum of capital is decided keeping in mind following
factors:
• Control
• Risk
• Cost
• It is difficult to achieve all of the above three goals together
• Finance manager has to make a balance among these three objectives

3. CAPITAL STRUCTURE THEORIES
It explain the relationship between cost of capital,capital structure and value of firm

4. CAPITAL STRUCTURE THEORIES
• Capital structure Relevance Theory
• Net Income Approach(NI)
• Traditional Approach
• Capital Structure Irrelevant Theory
• Net Operating Income(NOI)
• Modigliani Miller (MM) Approach
• Assumption:-
• There are only two kinds of funds used by a firm i.e. debt and equity.
• The total assets of the firm are given. The degree of average can be selling shares to retire debt.
• Taxes are not considered.
• The payout ratio is 100%.
• The firm’s total financing remains constant.
• Business risk is constant over time.
• The firm has perpetual life.

5. Net Income (NI) Approach
• According to this approach,
• Capital structure decision is relevant to the value of the firm
• An increase in financial leverage will lead to decline in the weighted average cost of capital
(WACC), this will increase the value of the firm as well as market price of equity share
• A decrease in the financial leverage will lead to an increase in the WACC,this will decline the
value as well as market price of equity shares.
Ke and Kd are assumed not to change with leverage. As debt increases, it causes weighted average
cost of capital (WACC) to decrease.

6. • On the basis of NI approach the value of firm
• Value of firm(V)=E+D
• E= Market value of equity
• D= Market value of Debt
• Market value of equity
• E= Earning available for equity share holders/Ke
• The value of the firm will be maximum at a point where weighted
average cost of capital (WACC) is minimum.
• Thus, the theory suggests total or maximum possible debt financing for
minimising the cost of capital
• The overall cost of capital under this approach

7. • The objective of the company
• Maximise the value of company
• While deciding the capital structure it should be our prime objective
• Capital Structure decision means
• Sources of capital
• Amount of capital
• Proportions of capital

8. Example
EBIT is Rs 50,00,000. The company has 10%, Rs200 lakh
debentures. The cost of equity (Ke) is 16%.
You are required to CALCULATE:
(i)Market value of equity and value of firm
(ii)Overall cost of capital.

9. Traditional Approach
• According to this approach up to certain level of financial leverage
cost of capital will decrease and value of firm increases.
• However, beyond certain level, cost of capital increase and value of firm
decrease
• The principle implication of this approach is that the cost of capital is
dependent on the capital structure and there is an optimal capital structure
which minimises the cost of capital

10. • The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it
increases
• The expected rate by equity shareholders remains constant or increase gradually. After that, the equity
shareholders starts perceiving a financial risk and then from the optimal point and the expected rate increases
speedily
• As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then
increases. The lowest point on the curve is optimal capital structure
• Optimum capital structure occurs at the point where value of the firm is highest and the cost of capital is the
lowest

11. Example:
• The company has EBIT of Rs 1,00,000. The company makes use of
debt and equity capital. The firm has 10% debentures of Rs 5,00,000
and the firm’s cost of equity is 15%.
You are required to compute
(i) Current value of the firm
(ii) Overall cost of capital.

12. From the following information calculate the
optimal capital structure
Optio
ns
Cost of
Debt(Kd)
in %
Cost of
Equity(ke) in
%
% of Debt on Total
value(D+E)
1 11 13 0.0
2 11 13 0.1
3 11.6 14 0.2
4 12 15 0.3
5 13 16 0.4
6 15 18 0.5
7 18 20 0.6

13. Decision:-option 2 is the best(lowest WACC)

14. Net Operating Income Approach (NOI)
• According to this approach,
• Capital structure decisions of the firm are irrelevant.
• Any change in the leverage will not lead to any change in the total
value of the firm and the market price of shares, as the overall cost of
capital is independent of the degree of leverage.
• As a result, the division between debt and equity is irrelevant.
• As per this approach, an increase in the use of debt which is
apparently cheaper is offset by an increase in the cost of equity
• This happens because equity investors seek higher compensation as they are
opposed to greater risk due to the existence of fixed return securities in the
capital structure.

15. The above diagram shows that Ko (Overall cost of capital) and (cost of debt) are constant and Ke
(Cost of equity) increases with leverage.

16. • XYZ Ltd’s operating income (EBIT) is Rs 5,00,000. The firm’s cost of
debt is 10% and currently the firm employs Rs 15,00,000 of debt. The
overall cost of capital of the firm is 15%.
You are required to CALCULATE:
• (i) Total Value of the firm
• (ii) Cost of equity

17. Modigliani-Miller Approach (MM)
• The NOI approach
• It does not provide operational justification for irrelevance of capital
structure.
• However, Modigliani-Miller approach provides behavioural justification for
constant overall cost of capital and therefore, total value of the firm

18. Particular LEV & Co. ULE & Co.
EBIT 1000000 1000000
Interest 300000 -
Net Profit 700000 1000000
Ke 20% 20%
Value of equity 3500000 5000000
Value of debt 3000000 -
Total value 6500000 5000000
Cost of capital(EBIT/V) 15.38% 20%
Two firm LEV & Co and ULE & Co are identical in all respect except that the LEV & Co. is a levered firm and has 10%
debt of ₹ 30,00,000 in its capital structure.ULE & Co is an unlevered firm and raised funds only by the issue of equity
share capital.Both these firms have an EBIT of ₹ 10,00,000 and cost of equity of 20%
Both LEV & Co and ULE & Co have same EBIT of ₹ 1000000 and same Ke of 20% and still the LEV & Co the levered
firm has a lower cost of capital and higher value as against the ULE & Co(unlevered firm)
MM argue that this position cannot persist for a longer and soon there will be an equality in the values of the two
firms

19. EBIT-EPS-MPS ANALYSIS
• The basic objective of financial management is to design an appropriate capital structure
which can provide the highest wealth, i.e., highest MPS, which in turn depends on EPS
• Given a level of EBIT, EPS will be different under different financing mix depending upon
the extent of debt financing.
• The effect of leverage on the EPS emerges because of the existence of fixed financial
charge i.e., interest on debt financial fixed dividend on preference share capital.
• The effect of fixed financial charge on the EPS depends upon the relationship between
the rate of return on assets and the rate of fixed charge.
• If the rate of return on assets is higher than the cost of financing, then the increasing use
of fixed charge financing (i.e., debt and preference share capital) will result in increase in
the EPS.
• This situation is also known as favourable financial leverage or Trading on Equity.
• On the other hand, if the rate of return on assets is less than the cost of financing, then
the effect may be negative and, therefore, the increasing use of debt and preference
share capital may reduce the EPS of the firm.

20. Interest Coverage Ratio(ICR)
• The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine how
well a company can pay the interest on its outstanding debts. The ICR is
commonly used by lenders, creditors, and investors to determine the riskiness of
lending capital to a company. The interest coverage ratio is also called the “times
interest earned” ratio.

21. Example
• Company A reported total revenues of Rs1,00,00,000 with COGS (costs of
goods sold) of Rs500,000. In addition, operating expenses in the most
recent reporting period were Rs120,000 in salaries, Rs 500,000 in rent, Rs
200,000 in repairs, and Rs100,000 in depreciation. The interest expense for
the period is Rs3,000,000. Calculate Interest coverage ratio
• EBIT= 10,00,000-COGS-operating exp= 85,80,000
• ICR=EBIT/Interest= 8580000/3000000=2.86
• ICR= EBIT+non cash items
• EBIT:-10,000,000-500000-120000-500000-200000-100000=8580,000
• Interest:-30,00,000
• ICR=8580000/3000000=2.86

22. Interpretation of ICR
• The lower the interest coverage ratio, the greater the company’s debt
and the possibility of bankruptcy
• lower ratio indicates that less operating profits are available to meet interest
payments and that the company is more vulnerable to volatile interest rates.
• Higher interest coverage ratio indicates stronger financial health – the
company is more capable of meeting interest obligations.
• As a rule of thumb, an ICR above 3 would be barely acceptable for companies
with consistent revenues and cash flows

23. Primary Uses of Interest Coverage Ratio
• ICR is used to determine the ability of a company to pay its interest
expense on outstanding debt.
• ICR is used by lenders, creditors, and investors to determine the
riskiness of lending money to the company.
• ICR is used to determine company stability – a declining ICR is an
indication that a company may be unable to meet its debt obligations
in the future.
• ICR is used to determine the short-term financial health of a
company.

24. When comparing the ICR’s of both Company A and B over a period of five years, we can see that Company A
steadily increased its ICR and appears to be more stable, while Company B showed a decreasing ICR and might face
liquidity issues in the future.

25. Debt Service Coverage Ratio(DSCR)
• The Debt Service Coverage Ratio (DSCR) measures the ability of a company to use
its operating income to repay all its debt obligations, including repayment of
principal and interest on both short-term and long-term debt.
• This ratio is often used when a company has any borrowings on its balance sheet
such as bonds, loans, or lines of credit.
• Interpretation of the Debt Service Coverage Ratio
• A debt service coverage ratio of 1 or above indicates that a company is generating sufficient
operating income to cover its annual debt and interest payments. As a general rule of thumb,
an ideal ratio is 2 or higher. A ratio that high suggests that the company is capable of taking
on more debt.
• A ratio of less than 1 is not optimal because it reflects the company’s inability to service its
current debt obligations with operating income alone. For example, a DSCR of 0.8 indicates
that there is only enough operating income to cover 80% of the company’s debt payments
• DSCR=EBDITA-Tax/Interest+principal

26. Particular Year 1 Year 2 Year 3 Year 4 Year 5
PAT -4.0 22.0 25.0 40.0 50.0
Depreciation 12.0 10.8 9.72 8.75 7.87
Interest on term
loan
21.1 21.2 20.5 17.8 15.2
Loan repayment
Instalment
- - 24.0 24.0 24.0
DSCR EBITDA=29.1
DSCR=29.1/(21.1
+0)=1.38
EBITDA=53.9
DSCR=53.9/(21.2
+0+=2.54
EBITDA=55.22
DSCR=55.22/(20.
5+24)=1.24
EBITDA=66.55
DSCR=66.55/(8.7
5+17.8)2.5
EBITDA=73.07
DSCR=73.07/(15.
2+24)=1.86

27. Uses of the Debt Service Coverage Ratio
• The debt service coverage ratio is a common benchmark to measure
the ability of a company to pay its outstanding debt including
principal and interest expense.
• DSCR is used by an acquiring company in a leveraged buyout to assess
the target company’s debt structure and ability to meet debt
obligations.
• DSCR is used by bank loan officers to determine the debt servicing
ability of a company

28. Financial Break Even point
• Financial break-even point is the earnings which are equal to the fixed
finance charges and preference dividend.
• Financial break-even point is the minimum level of EBIT needed to
satisfy all the fixed financial charges i.e. interest and preference
dividends.
• It denotes the level of EBIT for which the company’s EPS equals zero
• If the EBIT is less than the financial breakeven point, then the EPS will
be negative but if the expected level of EBIT is more than the
breakeven point, then more fixed costs financing instruments can be
taken in the capital structure, otherwise, equity would be preferred

29. Pecking order theory
• This theory is based on Asymmetric information, which refers to a situation
in which different parties have different information.
• In a firm, managers will have better information than investors.
• This theory states that firms prefer to issue debt when they are positive about future
earnings.
• Equity is issued when they are doubtful and internal finance is insufficient.
• Pecking order theory suggests that managers may use various sources for
raising of fund in the following order.
• Managers first choice is to use internal finance
• In absence of internal finance they can use secured debt, unsecured debt, hybrid
debt etc
• Managers may issue new equity shares as a last option

30. FACTORS DETERMINING CAPITAL STRUCTURE
• Choice of source of funds
• A firm has the choice to raise funds for financing its investment proposals from
different sources in different proportions. It can:
• Exclusively use debt (in case of existing company), or
• Exclusively use equity capital, or
• Exclusively use preference share capital (in case of existing company), or
• Use a combination of debt and equity in different proportions, or
• Use a combination of debt, equity and preference capital in different proportions, or
• Use a combination of debt and preference capital in different proportion (in case of existing
company).
• Financial leverage or Trading on Equity
• The use of long-term fixed interest bearing debt and preference share capital along
with equity share capital is called financial leverage or trading on equity.
• The use of long-term debt increases the earnings per share if the firm yields a return
higher than the cost of debt
• Interest is tax deductible

31. • Growth and stability of sales:
• The capital structure of a firm is highly influenced by the growth and stability of its sale.
• If the sales of a firm are expected to remain fairly stable, it can raise a higher level of debt.
• Similarly, the rate of the growth in sales also affects the capital structure decision.
• Greater the rate of growth of sales, greater can be the use of debt in the financing of firm.
• On the other hand, if the sales of a firm are highly fluctuating or declining, it should not employ, as far as
possible, debt financing in its capital structure
• Cost Principle
• According to this principle, an ideal pattern or capital structure is one that minimises cost of
capital structure and maximises earnings per share (EPS).
• For e.g. Debt capital is cheaper than equity capital from the point of its cost and interest
being deductible for income tax purpose, whereas no such deduction is allowed for
dividends.
• Control Principle
• While designing a capital structure, the finance manager may also keep in mind that existing
management control and ownership remains undisturbed.
• Issue of new equity will dilute existing control pattern and also it involves higher cost. Issue of
more debt causes no dilution in control, but causes a higher degree of financial risk.