Capital Structure

Capital structure refers to the composition of long-term sources of funds, such as debentures, long-term debt, preference share capital and ordinary share capital (equity shares) including reserves and surplus (retained earning)

Difference between Capitalization and Capital Structure

Capitalization merely refers to the determination of the amount of capital needed for successful business operation, whereas capital structure is concerned with the determination of proportion of different sources of long-term funds (Debenture, Bank Loan, Pref. Shares or Equity Shares) in the capitalization of a company. It is, therefore, capitalization is a quantitative aspect of the financial planning of an enterprise, while capital structure is concerned with the qualitative aspect.

Methods of analyzing Capital Structure

Probable Earning Per Share Method Probable Operating Profit Method Probable Market Price Per Share Method

Format of Probable Earning Per Share Method

Particulars Earning Before Interest & Tax (EBIT) (-) Interest Payable in Debt Capital
On Old Debt Capital On New Debt Capital

At Present X

Debentures

Preference Shares X

Equity Shares X

Earning Before Tax (EBT)

(-) Corporate Income Tax Earning After Tax (EAT) (-) Preference Share Dividend
On Old Pref. Capital On New Pref. Capital

Earning Available for Equity Shareholders

Earning Per Share (EPS) = Earning Avail. for Equity Shareholders No. of Equity Shares

Problem
The present earnings of the company before interest and taxes are 10% of the invested capital every year. The company is in need of Rs. 2,00,000 for purchasing a new plant and it is estimated that additional investment will also produce 10% earnings before interest & tax every year. The company has asked for your advise as to whether the requisite amount be obtained in the form of 5% Debentures, or 8% Cumulative Preference Shares or Equity Shares of Rs. 100 each to be issued at par. Examine the problem in all its bearing and advise the company. Assume an income tax rate of 50%. The existing capital structure of the company is as follows:
Sources of Capital 4000, 5% Debentures of Rs. 100 each 2000, 8%Pref. Shares of Rs. 100 each 4000 Equity Shares of Rs. 100 each Total Amount 4,00,000 2,00,000 4,00,000 10,00,000

Problem:- The Capital structure of a co. on 31st March 2005 was: 8% Debentures 12,00,000 9% Bank Loan 2,00,000 10% Preference Shares of Rs, 10 14,00,000 19,000 Equity Shares of Rs. 100 19,00,000 Reserve & Surplus 13,00,000 60,00,000 The present earnings before interest and tax are Rs. 9,00,000. It is hoped that this company will maintain the same rate of return. The company needs Rs. 10,00,000 for an expansion programme. For this following financing alternatives are available: (i) Issue of 9% debenture at par (ii) Issue of 10% Pref. Shares at par, (iii) Issue of equity shares at a premium of Rs. 25 Which alternative is the best for the company? Assume tax rate 50%