CAPITAL STRUCTURE: PLANNING AND DESIGNING

Smriti Chawla
Shri Ram College of Commerce
University of Delhi
CHAPTER OBJECTIVES

Capital Structure Management or planning

the Capital Structure

Essential features of sound capital mix

Factors determining capital structure

Profitability and Capital Structure: EBIT

EPS Analysis

Liquidity and Capital Structure: Cash Flow

Analysis

Illustrations

Lets Sum Up

Questions

Capital Structure Management or Planning The Capital

Structure
 Estimation of capital requirements for current and future needs is
important for a firm. Equally important is the determining of capital mix.
Equity and debt are the two principle sources of finance of a business. But,
what should be the proportion between debt and equity in the capital
structure of a firm now much financial leverage should a firm employ? This
is a very difficult question. To answer this question, the relationship
between the financial leverage and the value of the firm or cost of capital
has to be studied. Capital structure planning, which aims at the
maximisation of profits and the wealth of the shareholders, ensures the
maximum value of a firm or the minimum cost of the shareholders. It is very
important for the financial manager to determine the proper mix of debt
and equity for his firm. In principle every firm aims at achieving the optimal
capital structure but in practice it is very difficult to design the optimal
capital structure. The management of a firm should try to reach as near as
possible of the optimum point of debt and equity mix.

Essential Features of a Sound Capital Mix

A sound or an appropriate capital structure should have the

following essential features:

(i) Maximum possible use of leverage.

(ii) The capital structure should be flexible.

(iii) To avoid undue financial/business risk with the increase of

debt.

(iv) The use of debt should be within the capacity of a firm. The
firm should be in a position to meet its obligation in paying the
loan and interest charges as and when due.

(v) It should involve minimum possible risk of loss of

control.

(vi) It must avoid undue restrictions in agreement of debt.

(vii) The capital structure should be conservative. It should be

composed of high grade securities and debt capacity of the
company should never be exceeded.
 (viii) The capital structure should be simple in the sense that
can be easily managed and also easily understood by the
investors.

(ix) The debt should be used to the extent that it does not
threaten the solvency of the firm.
Factors Determining the Capital Structure

The capital structure of a concern depends upon a large number of

factors such as leverage or trading on equity, growth of the company, nature
and size of business, the idea of retaining control, flexibility of capital
structure, requirements of investors costs of floatation of new securities,
timing of issue, corporate tax rate and the legal requirements. It is not
possible to rank them because all such factors are of different importance
and the influence of individual factors of a firm changes over a period of
time. Every time the funds are needed. The financial manager has to
advantageous capital structure. The factors influencing the capital structure
are discussed as follows:

1. Financial leverage of 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, magnifies the earnings per share if the
firm yields a return higher than the cost of debt. The earnings per share
also increase with the use of preference share capital but due to the fact
that interest is allowed to be deducted while computing tax, the
leverage impact of debt is much more. However, leverage can operate
adversely also if the rate of interest on long-term loan is more than the
expected rate of earnings of the firm. Therefore, it needs caution to plan
the capital structure of a firm.

2. 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. Stability of sales ensures that the firm will not face any difficulty in
meeting its fixed commitments of interest repayments of debt. Similarly,
the rate of the growth in sales also affects the capital structure decision.
Usually 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.
3. Cost of Capital. Every rupee invested in a firm has a cost. Cost of
capital refers to the minimum return expected by its suppliers. The
capital structure should provide for the minimum cost of capital. The
main sources of finance for a firm are equity, preference share capital
and debt capital. The return expected by the suppliers of capital
depends upon the risk they have to undertake. Usually, debt is a cheaper
source of finance compared to preference and equity capital
due to (i) fixed rate of interest on debt: (ii) legal obligation to
pay interest: (iii) repayment of loan and priority in payment at the time
of winding up of the company. On the other hand, the rate of dividend is
not fixed on equity capital. It is not a legal obligation to pay dividend and
the equity shareholders undertake the highest risk and they cannot be
paid back except at the winding up of the company and that too after
paying all other obligations. Preference capital is also cheaper than
equity because of lesser risk involved and a fixed rate of dividend
payable to preference shareholders. But debt is still a cheaper source of
finance than even preference capital because of tax advantage due to
deductibility of interest. While formulating a capital structure, an effort
must be made to minimize the overall cost of capital.

4. Minimisation of Risk: A firms capital structure must be

developed with an eye towards risk because it has a direct link with the
value. Risk may be factored for two considerations: (a) the capital
structure must be consistent with the business risk, and
(b) the capital structure results in certain level of financial risk. Business
risk may be defined as the relationship between the firm's sales and its
earnings before interest and taxes (EBIT). In general, the greater the
firm's operating leverage the use of fixed operating cost the higher its
business risk. Although operating leverage is an important factor
affecting business risk, two other factors also affect it revenue stability
and cost stability. Revenue stability refers to the relative variability of
the firm's sales revenue. Firms with highly volatile product demand and
price have unstable revenues that result in high levels of business risk.
Cost stability is concerned with the relative predictability of input price.
The more predictable and stable these inputs prices are, the lower is the
business risk, and vice-versa. The firm's capital structure directly
affects its financial risk, which may be described as the risk resulting
from the use of financial leverage. Financial leverage is concerned with
the relationship between earnings before interest and taxes (EBIT) and
earnings per share (EPS). The more fixed-cost financing i.e., debt
 (including financial leases) and preferred stock, a firm has in capital
structure, the greater its financial risk.
5. Control: The determination of capital structure is also governed by
the management desire to retain controlling hands in the company. The
issue of equity share involve the risk of losing control. Thus in case the
company is interested in retaining control, it should prefer the use of
debt and preference share capital to equity share capital. However,
excessive use of debt and preference capital may lead to loss of control
and other bad consequences.
6. Flexibility: The term flexibility refers to the firms ability to adjust
its capital structure to the requirements of changing conditions. A firm
having flexible capital structure would face no difficulty in changing its
capitalization or source of fund. The degree of flexibility in capitals
structure depends mainly on (i) firms unused debt capacity ,
(ii) terms of redemption (iii) flexibility in fixed charges, and (iv)
restrictive stipulation in loan agreements.
If a company has some unused debt capacity, it can raise funds to meet
the sudden requirements of finances. Moreover, when the firm has a right to
redeem debt and preference capital at its discretion it will able to
substitute the source of finance for another, whenever justified. In essence,
a balanced mix of debt and equity needs to be obtained, keeping in view the
consideration of burden of fixed charges as well as the benefits of leverages
simultaneously.
7. Profitability: A capital structure should be the most profitable from
the point of view of equity shareholders. Therefore, within the given
constraints, maximum debt financing (which is generally cheaper) should
be opted to increase the returns available to the equity shareholder.
8. Cash Flow Ability: The EBIT EPS analysis, growth of earnings and
coverage ratio are very useful indicator of a firms ability to meet its
fixed obligations at various levels of EBIT. Therefore, an important
feature of a sound capital structure is the firms ability to generate cash
flow to service fixed charges.
At the time of planning the capital structure, the ratio of net cash
inflows to fixed charges should be examined. The ratio depicts the number
of times the fixed charges commitments are covered by net cash inflows.
Greater is this coverage, greater is this capacity of a firm to use debts an
other sources of funds carrying fixed rate of interest and dividend.
9. Characteristics of the company: The peculiar characteristics of
a company in regards to its size, nature, credit standing etc. play a
pivotal role in ascertaining its capital structure. A small size company will
not be able to raise long-term debts at reasonable rate of interest on
convenient terms. Therefore, such companies rely to a significant extent
on the equity share capital and reserves and surplus for their long-term
financial requirements.
In case of large companies the funds can be obtained on easy terms and
reasonable cost by selling equity shares and debentures as well. Moreover
the risk of loss of control is also less in case of large companies, because
their shares can be distributed in a wider range. When company is widely
held, the dissident shareholders will not be able to organize themselves
against the existing management, hence, no risk of loss of loss of control.
Thus, size of a company has a vital role to play in determining the capital
structure.
The various elements concerning variation in sales, competition with
other firms and life cycle of industry also affect the form and size of
capitals structure. If companys sales are subject to wide fluctuations, it
should rely less on debt capital and opt for conservative capitals structure. A
company facing keen competition with other companies will run the
excessive risk of not being able to meet payments on borrowed funds. Such
companies should place much emphasis on the use of equity than debt,
similarly, if a company is in infancy stage of its life cycle, it will run a high
risk of mortality. Therefore, companies in their infancy should rely more on
equity than debt. As a company grows mature, it can make use of senior
securities (bonds and debentures).
Capital Structure of a New Firm : The capital structure a new
firm is designed in the initial stages of the firm and the financial manager
has to take care of many considerations. He is required to assess and
evaluate not only the present requirement of capital funds but also the
future requirements. The present capital structure should be designed in
the light of a future target capital structure. Future expansion plans, growth
and diversifications strategies should be considered and factored in the
analysis.
Capital Structure of an Existing Firm: An existing firm may
require additional capital funds for meeting the requirements of growth,
expansion, diversification or even sometimes for working capital
requirements. Every time the additional funds are required, the firm has to
evaluate various available sources of funds vis--vis the existing capital
structure. The decision for a particular source of funds is to be taken in the
totality of capital structure i.e., in the light of the resultant capital
structure after the proposed issue of capital or debt.
Evaluation of Proposed Capital Structure : A financial manager
has to critically evaluate various costs and benefits, implications and the
after-effects of a capital structure before deciding the capital mix.
Moreover, the prevailing market conditions are also to be analyzed. For
example, the present capital structure may provide a scope for debt
financing but either the capital market conditions may not be conducive or
the investors may not be willing to take up the debt-instrument. Thus, a
capital structure before being finally decided must be considered in the
light of the firms internal factors as well as the investor's perceptions.
Profitability and Capital Structure: EBIT EPS Analysis
The financial leverage affects the pattern of distribution of operating
profit among various types of investors and increases the variability of the
EPS of the firm. Therefore, in search for an appropriate capitals structure
for a firm, the financial manager must analysis the effects of various
alternative financial leverages on the 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 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.
The fixed financial charge financing may further be analyzed with
reference to the choice between the debt financing and the issue of
preference shares. Theoretically, the choice is tilted in favour of debt
financing because of two reasons: (i) the explicit cost of debt financing i.e.,
the rate of interest payable on debt instruments or loans is generally lower
than the rate of fixed dividend payable on preference shares, and (ii)
interest on debt financing is tax-deductible and therefore the real costs
(after-tax) is lower than the cost of preference share capital.
 Thus, the analysis of the different capital structure and the effect of
leverage on the expected EPS will provide a useful guide to select a
particular level of debt financing. The EBIT-EPS analysis is of significant
importance and if undertaken properly, can be an effective tool in the hands
of a financial manager to get an insight into the planning and designing the
capital structure of the firm.
Limitations of EBIT-EPS Analysis: If maximization of the EPS is
the only criterion for selecting the particular debt-equity mix, then that
capital structure which is expected to result in the highest EPS will always
be selected by all the firms. However, achieving the highest EPS need not
be the only goal of the firm. The main shortcomings of the EBIT-EPS analysis
may be noted as follows:
(i) The EPS criterion ignore the risk dimension: The EBIT-
EPS analysis ignores as to what is the effect of leverage on the overall
risk of the firm. With every increase in financial leverage, the risk of
the firm and therefore that of investors also increase. The EBIGT-EPS
analysis fails to deal with the variability of EPS and the risk return
trade-off.
(ii) EPS is more of a performance measure: The EPS basically,
depends upon the operating profit which in turn, depends upon the
operating efficiency of the firm. It is a resultant figure and it is more a
measure of performance rather than a measure of decision-making.
These shortcomings of the EBIT-EPS analysis do not, in any way, affect its
value in capital structure decisions. Rather the following dimensions may be
added to the EBIT-EPS analysis to make it more meaningful.
The Risk Considerations: The risk attached with the leverage may
be incorporated in the EBIT-EPS analysis. The financial manager may start
by finding out the indifference level of EBIT (i.e., the level of EBIT at which
the EPS will be same for more than one capital structure). The expected
value of EBIT may then be compared with this indifference level of EBIT. If
the expected value of EBIT is more than the indifference level of EBIT, than
the debt financing is advantageous to the firm. The more is the difference
between the expected EBIT and the indifference level of EBIT, greater is the
benefit of debt financing, and so stronger is the case for debt financing.
In case, the expected EBIT is less than the indifference level of EBIT, then
the probability of such occurrence is to be assessed. If the probability is
high, i.e., there are more chances that the expected EBIT may fall below
the indifference level of EBIT, then the debt financing is considered to be
risky. If, however, the probability is negligible, then the debt financing may
be opted.
Debt Capacity: Whenever a firm goes for debt financing (howsoever
big or small), it inherently opts for taking two burdens, i.e., the burden of
interest payment and the burden of repayment of the principal amount.
Both these burdens are to be analyzed (i) from the point of view of liquidity
required to meet the obligations, and (ii) from the point of view of debt
capacity.
The profits of the firms vis--vis the burden of debt financing should also
be analyzed. The debt capacity or ability of the firm to service the debt can
be analyzed in terms of the coverage ratio, which shows the relationship
between the EBIT and the fixed financial charge. The higher the EBIT in
relation to fixed financial charge, the better it is. For this
purpose,Interest coverage ratio may be calculated as follows :
Interest Coverage Ratio = EBIT/Fixed Interest
Charge
Liquidty and Capital Structure: Cash Flow Analysis
A finance manager, while evaluating different capital structure, should
also find out the liquidity required for (i) interest on debt (ii) repayment of
debt, (iii) dividend on preference share capital, and (iv) redemption of
preference share capital. The requirement of liquidity should then be
compared with the cash availability from operations of the firm as follows:
1. Debt Service-Coverage Ratio: In the Debt Service Coverage
Ratio (DSCR), the cash profits generated by the operations are compared
with the total cash required for the service of the debt and the preference
share capital i.e.,

2. Projected Cash Flow Analysis: The firm may also

undertake the cash flow analysis for the period under consideration. This
will enable the financial manager to assess the liquidity capacity of the firm
to meet the obligations of interest payments and the repayment of principal
obligations. A projected-cash budget may be prepared to find out the
expected cash inflows and cash outflows (including interest and
repayments). If the inflows are comfortably higher than the outflow, then
the firm can proceed with the debt financing.
EBIT-EPS Analysis versus Cash flow Analysis (i.e.,
Profitability versus Liquidity): In the EBIT-EPS analysis, it has been
pointed out that a financial manager should evaluate a capital structure
from the point of view of the profitability of equity shareholders. A capital
structure which is expected to result in maximisation of EPS should be
selected. Financial leverages at different levels are considered so as to find
out their effect on the EPS.
On the other hand, in the cash flow analysis, the liquidity side of the
leverage is stressed. A capital structure should be evaluated in the light of
available liquidity. The firm need not face any liquidity problem in debt
servicing.
Under these two analyses, the different aspects of the capital
structure are evaluated. The EBIT-EPS analysis stresses the profitability of
the proposed financing mix and analyses it from the point of view of equity
shareholders. The cash flow analysis looks upon a financing mix and stresses
the need for liquidity requirement of debt financing and thus, it emphasizes
the debt investor.
Financial Distress
An increase in debt thus increases the probability of financial
distress. The financial distress is a situation when a firm finds it difficult
to honor its commitment to the creditors/debt investors. With reference to
capital structure, the financial distress refers to the situation when the firm
faces difficulties in paying interest and principal repayments to the debt
investors. Financial distress arises when the fixed financial obligations of
the firm affect the firm's normal operations. There are many degrees of
financial distress. One extreme degree of financial distress is the
bankruptcy, a condition in which the firm is unable to meet its financial
obligation and faces liquidation. The firm should try to achieve a trade-off
between the costs and benefits of debt financing. The cost being the
financial distress and the benefits being the interest tax-shield. The
financial manager must weigh the benefits of tax savings against the cost of
financial distress in the form of increasing risk. The cost of financial distress
is reflected in the market value of the firm and can be measured therefore,
through its effect on the value of the firm. Lower levels of leverage will
have little effects, but as the financial leverage increases, the cost of
financial distress increases and the market value of the debt as well as the
equity falls.
 In view of the cost of financial distress, the market value of the firm
may not be as much as it could have been in absence of such costs. Thus,
the value of the firm is:
Value = Value (fall equity firm) + Present value of tax-shield Present value
of cost of financial distress.
Illustration 1: Alpha company is contemplating conversion of 500
14% convertible bonds of Rs.1,000 each. Market price of bond is Rs.
1,080. Bond indenture provides that one bond will be exchanged for
10 share. Price earning ratio before redemption is 20:1 and
anticipated price earning ratio after redemption is 25:1.Number of
shares outstanding prior to redemption are 10,000. EBIT amounts
to Rs 2,00,000. The company is in the 35% tax bracket. Should the
company convert bonds into share? Give reasons.
Solutions:

Present Position
After Conversion
EBIT Rs.2,00,000
Rs.2,00,000
Less interest @ 14% 70,000 ---
1,30,000 2,00,000
less tax @15% 45,500 70,000
Number of share 10,000 15,000
EPS Rs. 8.45 Rs. 8.67
P E Ratio 20 25
Expected market Price Rs. 169.00 Rs. 216.75

The company may opt for conversion of bonds into equity shares as this will
result in increase in market price of share from Rs.169 of Rs.216.75.
Lets Sum Up
The relationship between capital structure, cost of capital and value
of firm has been one of the most debated area of financial management.
Factors determine capital structure are control, flexibility,
characteristic of company, profitability, cash flow ability, cost of capital,
minimization of risk, trading leverage.
 Two basic techniques available to study the impact of a
particular capital structure are (i) EBIT EPS Analysis which studies
the impact of financial leverage on the EPS of the firm and (ii) Cash Flow
Analysis which emphasizes the liquidity required in view of particular
capital structure.
Different accounting ratios such as interest coverage ratio and debt
service coverage ratio may be ascertained to find out the debt capacity
of the firm and the cash profit generated by the firm which may be used
to service the debt.
The financial manager should also take care of the financial distress
which refers to the situation when the firm is not able to met its
interest / repayment liabilities and may even face a closure.