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CAPITAL STRUCTURE DECISIONS

When a firm is seeking financing for a project it is usually a choice between additional
debt financing or an additional equity issue, assuming internally generated funds are not
sufficient.
The chosen option of financing can make a difference to EPS (earnings per share ), which
is an important investment analyst ratio.
Example :
Assume Cherokee Tire Cos long term capitalization of $18 mill is as follows :
Debt
$5 mill @ 9 per cent.
Shareholders Equity $13 mill.
The company wishes to raise $5 mill for expansion. It has 3 options ;
i.
ii.
iii.

Issue 100,000 new common stock @ $50.00 each

Issue new debt @ 8%
Issue preferred stock with a 7.6 % dividend.

Present EBIT are $3 mill, and corp. tax rate is 40%

There are 400,000 shares of common stock presently outstanding.
Suppose EBIT is expected to move to $4 mill after expansion, what would EPS be under
each financing option.
Common Stock
$
Estimated EBIT
Interest on existing debt
New debt interest
Earnings before taxes
Taxes @ 40%
After tax earnings
Preferred dividend
Earnings available to common
stockholders
Number of shares
Earnings per share ( EPS )

Debt
$

4,000,000
450,000
---3,550,000
1,420,000
2,130,000

4,000,000
450,000
400,000
3,150,000
1,260,000
1,890,000

------------

-------------

2,130,000

1,890,000

500,000
$4.26

400,000
$4.73

Pref. Stock
$
4,000,000
450,000
.
3,550,000
1,420,000
2,130,000
380,000
-----------1,750,000
400,000
$4.38

Earnings available to common stockholder is higher under debt than preference shares
because of the debt tax shield, even though the cost of debt ( before tax ) is higher than
the cost of Pref. Shares. Also EPS is highest under debt.

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However, what is the indifference point for financial leverage ? That is, the level of
EBIT below which financing with a common stock alternative will provide higher
earnings per share.
Mathematical solution :
EBIT* - C1
S1
Where EBIT*
C1 and C2
S1and S2

= EBIT* - C2
S2

= the EBIT indifference point between the two methods of financing.

= the annual interest expense or preferred stock dividends on a before tax basis for
methods 1 and 2 .
= the number of shares of common stock after financing methods 1 and 2
EBIT* - 450,000
500,000

EBIT* - 850,000
400,000

( EBIT* )( 400,000) ( 450,000)( 400,000) = ( EBIT*)( 500,000) (850,000)( 500,000)

100,000 EBIT* = 245,000,000,000
EBIT *
= $2,450,000

Graphical Presentation

MATTERS TO TAKE ACCOUNT OF WHEN MAKING CAPITAL STRUCTURE DECISION

1.Cash Flow Ability to Service Debt

When considering the appropriate capital structure we should analyze the cash flow
ability of the firm to service fixed charges. The greater the dollar amount of debt the
company issues, and the shorter their maturity, the greater is the fixed charge on the
company.
2.Coverage of interest by earnings.
This is an important test of credit worthiness.
Coverage ratio : Times interest earned = EBIT
Interest on debt
If EBIT = $6 mill and interest on debt payments = $1.5 mill, coverage would be 4 times.
This tells us that EBIT can drop to up to 75% and the firm will be able to cover interest
payment out of earnings.

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3.Debt Service Coverage
This takes into account Principal repayments.
Debt service coverage =
EBIT
Interest + [ Principal/ (1- tax rate)]
e.g. if principal payment is $1 mill per annum :
Debt service coverage =

$6 mill
= 1.89 times.
$1.5 m + [ $1mill/ ( 1- .4)]

A coverage of 1.89 means that EBIT can fall by 47% before earnings coverage is
insufficient to service debt [ 1- ( 1/ 1.89) ] = .47 or 47%.
The financial risk associated with leverage should be analyzed on the basis of the firms
ability to service total fixed charges.
The Donaldson approach
Gordon Donaldson advocates examining the cash flows of the company under the most
adverse circumstances i.e. under recession conditions. The net cash balance in a recession
is :
CBr
Where

= CBo

NCFr

CBo = the cash balance at the start of the recession

NCFr = Net cash flow during a recession.

You should calculate a probability distribution of expected behaviour of a firm during a recession.
The beginning cash balance, CBo, should be combined with the probability distribution of recession cash
flows, NCFr, to give a probability distribution of cash balances in recession.

Debt capacity.
A company should know how much debt can be comfortably serviced.
First, calculate the fixed charges associated with each increment of debt.
For each addition, the firm would determine a probability of running out of cash.
By this method a probability distribution can be obtained.
Effect on debt ratio :
Debt ratios should be computed for various financing alternatives being considered. Also,
new debt ratios should be compared with other companies having similar business risk
e.g. those in the industry, Debt ratio can affect the ability of the company to raise debt
capital.

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Effect on Security ratings :
Whenever a company sells a debt or preferred stock issue to the public ( as opposed to a
private placement) it must have the issue rated by a rating service. In the USA Moodys
Investors Service and Standard & Poor are well known. Security ratings indicate the
credit worthiness of the borrower.