Form of Capital:

Capital Structure

Terminologies

Capitalization
Capital
Structure
Financial
Structure

Capitaliza
tion

Total
amount of
(in )
issued by a
company

Balance
Sheet
Current Liabilities

Current Assets

Debt
Preference Shares
Fixed Assets
Equity Shares
Retained Earnings

Balance
Sheet
Current Liabilities

Current Assets

Debt

Capital
Struct
ure
(%
mix)

Preference Shares
Fixed Assets
Equity Shares
Retained Earnings

Balance
Sheet
Current Liabilities

Financ
ial
Struct
ure
(%

Current Assets

Debt
Preference Shares
Fixed Assets
Equity Shares
Retained Earnings

What does it
Conclude !!

Capital Structure =
Financial
Current
Structure
liabilities

Kinds of Capital Structure

Expansion

Equity Share
Capital
+ Retained
Earnings
Debt +
Preference

Foundation

Share
Debt

Horizontal

Vertical

Pyramid
Shaped

Inverte
d
Pyrami

Importance of Capital Structure:

Ind
ris icato
kp
ro
of
th rofl f
ef e
rm

s
a
s
Act
a
g
a
n
ma
t
n
e
m
e
tool

Reflects
the
firms
strategy

Financial Break-Even Point

Level of EBIT which is just equal to pay the total financial charges.

At this point EPS = 0.

Critical point in planning capital structure of firm.

If EBIT < financial break even point, then debt and preference
share capital should be reduced in capitalization.

If EBIT> financial break even point more of fixed cost may be

inducted in capital structure.

When capital structure consists of

Point of Indifference/ Range of Earnings

It is EBIT level at which
EPS remains the same ;
irrespective of different alternatives of debtequity mix.

At this level of EBIT,

rate of return on capital employed = cost of debt.

 Calculation of Point of Indifference

(algebraically):
(X-I1) (1-T) PD
S1

= (X-I2) (1-T)- PD
S2

WHERE, X = point of indifference,

I1 = interest under alternative financial plan 1,
I2 = interest under alternative financial plan 2,
T= tax rate,
S1 = no of equity shares under financial plan1,
S2 = no of equity shared under financial plan 2,
PD= preference dividend.

A project under consideration by your company requires a

capital investment of 60 lakhs. Interest on loan 10 % p.a
and tax rate 50%. Calculate point of indifference for the
project, if debt equity ratio is 2:1.

As debt equity ratio is 2:1. So, Company has two

alternatives :
(i) Raising entire amount by issue of share capital and no
debt.
(ii) Raising 40 lakh by way of debt and 20 lakh by issue of
equity share capital.
Calculation of point of indifference:
(X-I1) (1-T) PD = (X-I2) (1-T)- PD
S1
S2
I1 = 0 , I2 = 40* 10% = 4 , tax rate = 50 % or .5 , S 1= 60,
S2 = 20
now substitute the values,
(X-0) (1-0.5) 0 = (X-4) (1-0.5) 0
60
20
20 (.5X) = 60 (.5X-2)
10X = 30X-120
X=6
Thus, EBIT at point of indifference is 6 lakhs.

Graphically :

i
Equ y
t

EPS (Rs.)

b
De

Indifference point

EBIT (Rs. In lakhs)

Point of indifference and

uncommitted earnings per share
Equivalency point for uncommitted EPS can be calculated as
below:
(X-I1) (1-T) PD-SF = (X-I2) (1-T)- PD- SF
S1 S2
where, X = Equivalency point or point of indifference
I1 = interest under alternative financial plan 1,
I2 = interest under alternative financial plan 2,
T= tax rate,
S1 = no of equity shares under financial plan1,
S2 = no of equity shared under financial plan 2,
PD= preference dividend.
SF= sinking fund obligations

Optimal Capital
Structure

Considerations to be kept in mind while

maximising value of firm:

Company should make maximum possible use of leverage to increase EP

Risk-Return Trade Off

Capital mix involves two types of risks:

1. Financial Risk
2. Non-Employment of Debt Capital
Risk (NEDC)

Financial Risk

Sales
Operating () Variable costs

Debt causes

Leverage

financial risk !

Contribution
() Fixed costs
EBIT / Profit

The use of debt

financing is referred
to as financial
leverage.

Financial leverage
measures Financial
risk.

() Interest expense
Financial

EBT

Leverage () Taxes
EAT
(-) Preference dividend
Earnings available for
equity Shareholders

Non-Employment of Debt Capital

(NEDC) Risk
No advantage of Financial leverage.
Loss of control by issue of more and more

Equity.
Higher Floatation Cost.

Strike a balance (trade off) between

the fnancial risk
and
Risk of non-employment of debt
capital
to increase
Firms Market Value.

Theories of Capital Structure

1. Net Income Approach
2. Net Operating Income Approach
3. The Traditional Approach
4. Modigliani and Miller Approach

PURPOSE OF STUDY
VALUE OF FIRM

1. NET INCOME
APPROACH
ASSUMPTIONS:

IMPLICATIONS
INCREASE IN FIRMS
PROPORTION
OF CHEAP
DEBT
VALUE
INCREASES
SOURCE OF FUNDS INCREASE

CONT
DECREASE LEVERAGE
FINANCIAL
PROPORTION
IN OF
FIRMSVALUE
DEBTIS
FINANCING
REDUCED DECREASES

Calculation

of

THE TOTAL MARKET VALUE OF A

FIRM

V=S+D
Where, V= Total market value of a firm
S= Market value of equity shares
Earnings available to equity shareholders (NI)
Equity Capitalization Rate
D = market value of debt
And, Overall Cost of Capital (Weighted Average Cost of Capital)

K0 =

EBIT

A company expects a net income of Rs. 80,000. It has

Rs. 2,00,000, 8% debentures. The equity
capitalization rate of the company is 10%.
Calculate:
(a) the value of the firm & overall capitalization rate.
(b) If the debenture debt is increased to Rs 3,00,000,
what shall be the value of the firm & overall
capitalization rate?

Solution

Particulars

Rs

Rs

80,000

80,000

(16000)

(24000)

64000
10%

56,000
10%

Market value of equity(s)

6,40,000

5,60,000

Market value of debentures(D)

2,00,000

3,00,000

Value of the firm (S+D)

8,40,000

8,60,000

(80,000/8,40,000)
X100
=9.52%.

(80,000/8,60,0
00)X100
=9.30%

Net income
Less interest on 8% debentures of
Rs .2,00,000/3,00,000
Earnings available to equity shareholders
Equity capitalization rate

Overall cost of capital

2. NET OPERATING INCOME

APPROACH
ASSUMPTIONS:

IMPLICATIONS

INCREASED USE OF DEBT INCREASES FINANCIAL RISK OF THE EQUITY S

Ascertainment of value of firm

V= EBIT/KO
V= Value of the firm
EBIT= Net operating income or
earnings
before interest & tax
KO= Overall cost of capital
S= V-D
S= Market value of equity shares
V= total market value of a firm
D= market value of debt

A company expects a net operating income of

Rs.1,00,000. It has Rs 5,00,000 6% debentures. The
overall capitalization rate is 10%. Calculate the value
of the firm & cost of equity according to net
operating income approach. If the debenture debt is
increased to Rs 7,50,000. What will be the effect on
the value of the firm % the equity capitalization
rate?

Solution

PARTICULARS
Net operating income
Overall cost of capital (Ko)
Market value of the firm=
EBIT/Ko (100000x100/10)

Market value of the firm(v)

Less market value of
debentures (D)
Total market value of equity
Cost of equity=
(EBIT-I) x 100
(V-D)

RS

RS

1,00,000

1,00,000

10%

10%

10,00,000

10,00,000

10,00,000
(5,00,000)

10,00,000
(7,50,000)

5,00,000

2,50,000

(1,00,000-30,000) x (1,00,000-45000) x
100
100
10,00,000-5,00,000
10,00,0007,50,000
=14%.
=22%

3. Traditional approach
Implications:

USE OF DEBT INITIALLY

BUT
INCREASED USE OF DEBT
..

Compute:
Market value of Firm, Value of shares, and Average
cost of Capital
Particulars

Rs.

Net operating income

2,00,000

Total investment

10,00,000

Equity capitalization rate

a. If the firm uses no debt

10%

b. If the firm uses Rs 4,00,000 debentures

11%

c. If the firm uses Rs 6,00,000 debentures

13%

Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest

whereas Rs. 6,00,000 debentures can be raised at 6% rate of interest.

Solution
(a) No debt

(b) Rs 4,00,000 5%
debentures

Net operating income

Less int.
Earnings available to

(c) Rs. 6,00,000 6%

debentures

2,00,000

2,00,000

2,00,000

(20,000)

(36,000)

2,00,000

1,80,000

1,64,000

10%

11%

13%

20,00,000

16,36,363

12,61,538

4,00,000

6,00,000

20,00,000

20,36,363

18,61,538

2,00,000/20,00,000X100

2,00,000/20,36,363X100

2,00,000/18,61,538

=10%

=9.8%

X100

eq. Sh.Holders
Eq. Capitalization rate
Market value of
shares
Market value of debt
Market value of firm
Average cost of
Capital =EBIT/v

=10.7%

4. Modigliani & Miller Approach

Implications
Cost of capital not influenced
by changes in capital structure

Debt-equity mix is irrelevant in

determination of market value of
frm

(B) WHEN TAXES ARE ASSUMED

TO EXIST
USE OF DEBT

Implication:

The mix of debt, preferred stock,

and common stock the frm plans
to use over the long-run to
fnance its operations.

Features of a Optimal
Capital Mix
Optimum capital structure is also
referred as appropriate capital
structure and sound capital structure
Capacity of a FIRM
Possible use of LEVERAGE
FLEXIBLE
Avoid Business RISK
MINIMISE the cost of Financing and
MAXIMISE earning per share

Factors determining capital

structure

A company is considering 4 different plans to

finance its total project cost of Rs 5,00,000

Equity(Rs.
10 per
share)

Plan I

Plan II

Plan III

Plan IV

5,00,000

2,50,000

2,50,000

2,50,000

8%
Preference
Shares
Debt (8%
Debenture)

2,50,000

5,00,000

5,00,000

1,00,000

2,50,000

1,50,000

5,00,000

5,00,000

Plan I

Plan II

Plan III

Plan IV

1,00,000

1,00,000

1,00,000

1,00,000

20,000

12,000

1,00,000

80,000

88,000

50,000

50,000

40,000

44,000

50,000

50,000

40,000

44,000

NIL

20,000

NIL

8,000

Earning
50,000
available for
eq.Shareholde
rs (A)

30,000

40,000

36,000

No. of
Equity
Shares(B)

25,000

25,000

25,000

EBIT

Less:
Interest on
Debentures 1,00,000
EBT
Less: Tax
@50%
Earning
after
Interest and
Tax
Less:
Preference
Dividend

50,000

PRINCIPLES OF CAPITAL
STRUCTURE

CAPITAL GEARING

The term "capital gearing" or "leverage" normally refers to

the proportion of relationship between equity share capital
including reserves and surpluses to preference share capital
and other fixed interest bearing funds or loans.

It is the proportion between the fixed interest or dividend

bearing funds and non fixed interest or dividend bearing
funds.

Equity share capital includes equity share capital and all

reserves and surpluses items that belong to shareholders.
Fixed interest bearing funds includes debentures,

HOW TO CALCULATE

Formula of capital
gearing ratio:[Capital Gearing Ratio
= Equity Share Capital /
Fixed Interest Bearing
Funds]

EXAMPLE
1992
EQUITY
5,00,000
SHARE
CAPITAL
RESERVES
3,00,OOO
AND
SURPLUSES
LONG TERM 2,50,000
LOANS
6%
2,50,000

1993
4,00,000

2,00,000

3,00,000
4,00,000

CALCULATION
Capital Gearing Ratio
1992 = (500,000 + 300,000) / (250,000 +

250,000)
= 8 : 5 (Low Gear)
1993 = (400,000 + 200,000) / (300,000
+400,000)
=6 : 7 (High Gear)
It may be noted that gearing is an inverse ratio to
the equity share capital.
Highly Geared------------Low Equity Share Capital
Low Geared---------------High Equity Share Capital

SIGNIFICANCE
Capital gearing ratio is important to
the company and the prospective
investors. It must be carefully
planned as it affects the company's
capacity to maintain a uniform
dividend
policy
during
difficult
trading periods. It reveals the
suitability
of
company's
capitalization.

REASONS FOR CHANGE IN

CAPITAL STRUCTURE :-

1.)

2.) Simplify the capital structure

This will
When
market
lead to
conditions
simplification
are favorable
of financial
various
plan securities at
different point of time can be consolidated.

3.)To suit the need of

investors

4.)To fund current liabilities

5.)To write off deficit

A company may need to re-organize its capital by reducing book value

6.)To capitalise retained

earnings
To avoid over-capitalisation

7.)To clear defaults on fixed cost

securities:-

When the company is not in a position to pay interest on debentures or

8.)To fund accumulated

dividend
When its time to pay fixed dividends to its preference shareholders

9.)To facilitate merger and

expansion
To facilitate merger and expansion

10.)To meet legal

requirements
To meet the legal requirements

Financial Distress and Capital

Structure
Financial risk increases when firm uses more debt;
it may not be able to pat fixed interest and runs into
bankruptcy.

Firms using more equity don't face this problem.

Use of debt provides tax benefit but bankruptcy

costs work against the advantage.
When firm raises debt, suppliers put restrictions in
agreement resulting to less freedom of decision
making by management called agency cost.

Pecking Order Theory

This theory was suggested by DONALDSON in 1961.
It was modified by MYERS in 1984.
According to Donaldson,
o Firm has well defined order of preference for raising
finance.
o When firm need funds it will rely on internally
generated funds.
o This order of preference is so defined because
internally generated funds have no issue costs.

According to modifed
pecking order theory,
o Order of preference for raising funds arises
because of asymmetric information between
market and firm.
o Firm may prefer internal funds and then raising
of debt as compared to issue of new equity share
capital.

Manisha
Joshi
BY