Capital Structure

By:Akhil Sarda Vishwak Kasturi Ashwin Disha Prabhas Chitrasen Shabya

Contents
Definition

Concept of Optimal Capital Structure

Significance of Capital Structure Features of Appropriate Capital Structure

Elements of Capital Structure

Determinants of Capital Structure Approaches to establish Capital Structure Evaluation of Capital Structure

DEFINITION
The permanent long-term financing of a company including long term debt, common stock and preferred stock and retained earnings. Its is different from financial structure which includes short term debt and accounts payable.

Debt comes in the form of bond issues or long-term notes payable, whereas equity is classified as common stock, preferred stock, or retained earnings.
The capital structure is the firm's various sources of funds used to finance its overall operations and growth. The capital structure of a business enterprise should be ideal , that is according to the requirement of the business enterprise.

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Preference hares

Fixed Assets

Ordinary shares

Capital Structure

For Example
A company has equity shares of RS. 5,00,000 and reserves and surplus RS. 2,00,000 and Debentures of RS. 3,00,000. The total long term capital or capitalization is RS. 10,00,000.and the capital structure of the firm or the mix of capitalization consists equity , retained earnings and debentures.

Concept of optimal capital structure

The capital structure that minimizes the firm's cost of capital and thereby maximizes the value of the firm. The optimal capital structure is obtained when the market value per share is at maximum or the average cost is minimum.

The determination of capital structure is formidable task because a no. of factors influence the capital structure of the company.

Significance of capital structure

It is concerned with the formulation and designing of proper capital structure . The most important decision of any company is involved in the formulation of an appropriate capital structure.

Capital structure will maximize the earning per share of shareholders.

The design of the capital structure of a company has some bearing on the profitability and influence on the risk and return of the shareholders.

A conservative policy may deprive the firm of its benefits in terms of magnifying the rate of return of its equity shareholder. This is concerned with the determination of debtequity combination.

If capital structure is appropriate it may improve the and solvency position of the company.

Features of capital structure

The cost of capital should be minimum.

The debt should be in limits.

It should be flexible and adoptable. It should not dilute the control of the company.

ELEMENTS OF CAPITAL STRUCTURE

Debt-Equity Mix:
Firms should establish a standard debt- equity ratio for their capital structure.

Terms and conditions:

Interest payments may be based on fixed or floating rates of interest. It should also keep in view the terms and conditions laid down in the loan agreements or debt instruments.

Priority and Maturity:

Securities differ in case of maturities and also priority of payments.

Currency:
allowed to

In recent times, companies are mobilize funds from overseas markets .

Financial Innovations:

Innovation has made the securities more attractive to investors and reduces cost of capital to the company.

Financial market segments:

Financial markets have different segments.

Determinants of Capital Structure

experiencing variation in their net operating income rely more on equity than debt and others with stable earnings add more debt.

The degree of business risk :- Companies

avoid the issue of new equity shares.

Control :- For retaining control, companies should

Capital Market Condition:- Capital market condition

influence the capital structure of a company.

 Government Regulations :- Government regulations

influence the financing pattern of a company through legislation.

Attitude Towards Risk : The attitude of

management towards risks plays a vital role in shaping the capital structure plan.

Cost Of Capital :- It is a important factor which

formulate the capital structure.

Flexibility : The capital structure must be flexible and have debt reserve capacity. Size Of The Company :- Influences the availability

of funds from different sources.

EPS, is one of the important factor in capital structure planning. High leverage results in high EPS and vice versa.

Trading On Equity :- Financial leverage effects on

APPROACHES TO ESTABLISH TARGET CAPITAL STRUCTURE

EBIT-EPS approach: for analyzing the impact of debt on
EPS

Valuation approach: for determining the impact of debt

on the share holders value

Cash flow approach: for analyzing the firms ability to

service debt

EBIT-EPS ANALYSIS
It refers to that EBIT level at which EPS remains the same irrespective of different alternatives of debt equity mix.
At this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also known as break-even level of EBIT for alternative financial plans.

Effect of Financial Plan on EPS : Constant EBIT

Q.1. Suppose a firm is unlevered consisting of 1 lacs ordinary shares of Rs. 10 each. The firm wants to raise Rs. 2,50,000 to finance its investments and is considering two alternative methods of financing: a. b. To issue 25,000 ordinary shares at Rs. 10 each To borrow Rs. 2,50,000 at 8% interest rate. If the firms earnings before
1. Earnings before interest and taxes, EBIT 2. Less: interest, INT 3. Profit before taxes, PBT = EBIT INT 4. Less: Taxes, T (EBIT INT) 5. Profit after taxes, PAT = (EBIT INT) (1 T) 6.Less:preference dividend Financial Plan Debt-equity (Rs) 312500 20000 292500 146250 146250 0 All-equity (Rs) 312500 0 312500 156250 156250 0

interest and taxes after additional

investment are Rs. 3,12,500 and the tax rate is 50%. What is the effect of alternatives on EPS?

7.Earning available to ordinary shareholders

8.Shares outstanding 9. EPS

146250
100000 1.46

156250
125000 1.25
17

VALUATION APPROACH
Determines the impact of debt on the shareholders value High debt increases the cost of financial distress & agency cost Trade off between tax shield and cost of financial distress & agency cost Firm should employ debt to the point the marginal benefits & costs are equal

WHAT IS CASH FLOW

Payroll Inventory Utilities Rent Taxes Interests Loans Etc. Products / Services Cash out

Business

Customers Cash In

Equity and/or Debt financing

CASH FLOW ANALYSIS

In determining a firms target capital structure, a key issue is the firms ability to service its debt. The focus of this analysis is also on the risk of cash insolvency-the probability of running out of the cash given a particular amount of debt in the capital structure This analysis is based on a through cash flow analysis and not on rules of thumb based on various coverage ratios

Components of cash flows:

This type of analysis is done through the preparation of proforma cash flow statements.
It is grouped into three kinds.
Operating cash flows: It is generated from the main operations of the business and determined from the projected financial statements. Non-operating cash flows: Normally capital expenditure and working capital changes included. Financial flows: Payment of interest and dividends and repayment of debt, lease rentals and other financial charges are included.

EVALUATION OF CAPTIAL STRUCTURE:

Capital structure is evaluated from different points of view. In the view of shareholders return, risk and value are most important.

From the strategic point of view, flexibility is important.

A sound capital structure must posses all these factors.

The main consideration are follows:

Flexibility
The debtequity mix should be within the debt capacity. In other words the capital structure should be flexible.

Risk

Usage of more debt adds to the profitability of the shareholders. It also adds financial risk to the company.

Return

The objective of the capital structure is to minimize the cost and maximize the market value of the shares.

Control

The capital structure should not result in parting with the control of the company.

Timing

While designing a capital structure, the current and future capital market condition should be taken into account.

Particulars EBIT Less-Interest Net Income(NI) Ke

Plan 1 450000 45000 405000 .12

Plan 2 450000 60000 390000 .125

Plan 3 450000 82500 367500 .135

Plan 4 450000 108000 342000 .15

Plan 5 450000 147000 303000 .18

Value of Equity(S) Value of Debt(D)

V(S+D) Ko(EBIT/V)*100

3375000 450000
3825000 11.76

3120000 600000
3720000 12.10

2722222 750000
3472222 12.95

2280000 900000
3180000 14.15

1683333 1050000
2733333 16.46

Bibliography
I. M.Pandey