Capital Structure Decisions

Dr. A. K. Sinha

Scope of Discussions
What is Capital Structure? How a capital structure affects the wealth of the Shareholders? Various analysis that helps in capital structure decisions: 1. EBIT-EPS and ROI-ROE Analysis 2. Leverage and Ratios 3. Cash Flow and Comparative analysis
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Capital Structure
How the assets of a firm are funded or what type of liabilities have been used to finance assets ? Owners capital and Borrowed Capital Equity and Debt Debt-Equity Ratio = Long-term Debt / Net Worth

Capital Structure of Nirma Limited

Rs. In Crores as at 31.03.2011 Shareholders Funds Share Capital Reserves and Surplus Net Worth 79.57 2752.40 2831.97 79.57 2675.89 2755.46 Rs. In Crores as at 31.03.2010

Loan Funds
Secured Loans Unsecured Loans Total Long Term Debt Debt Equity Ratio 875.03 115.36 990.39 0.35:1 751.97 235.31 987.28 0.36:1
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Capital Structure & Wealth of the Shareholders

Can a firm be only Equity Financed ? Can a firm be 100 per cent debt financed ? Does Borrowings help in increasing the wealth of the shareholders ? If yes, to what extent a firm should borrow ? What is the relationship between borrowings & risks ?
Lets understand EBIT-EPS (ROI ROE) analysis with examples.
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Example
A Ltd. B Ltd.

Capital Employed

Rs. 10 lakh (Equity Share-1 lakh of Rs.10 each)

Rs.1,80,000 NIL Rs.1,80,000 Rs.54,000 Rs. 1,26,000 1,26,000/1,00,000 Rs. 1.26

Rs. 10 Lakh (Equity Share-50000 of Rs. 10 each and Debt-Rs.500000 @ 12 %)

Rs. 1,80,000 Rs.60,000 Rs.1,20,000 Rs.36,000 Rs. 84,000 84,000/50,000 Rs.1.68
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ROI 18 % = EBIT Less Interest (I) EBT Less Tax ( T) @ 30 % EAT Return on Equity EPS

Evaluating Different Financing Plans

FINANCING PLANS All Equity A B C 50% 1,000 500 500 10% 15% 150 50 100 40 60 50 D E Debt Ratio 0% 10% 30% Cost of the Project 1,000 1,000 1,000 Equity 1,000 900 700 Debt 0 100 300 Cost of debt 10% 10% 10% Return on Assets 15% 15% 15% EBIT Interest EBT Tax 40% PAT Nos. of shares EPS (Rs./Share)
RoE

70% 90% 1,000 1,000 300 100 700 900 10% 10% 15% 15% 150 70 80 32 48 30 150 90 60 24 36 10 3.60

150 0 150 60 90 100

150 10 140 56 84 90

150 30 120 48 72 70

9.0% 9.3% 10.3% 12.0% 16.0% 36.0%

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0.90 0.93 1.03 1.20 1.60

Business Conditions and ROE

BUSINESS SCENARIO Investment 1,000 Return on Assets Bad Fair Normal Good V Good

5%

10%

15%

20%

25%

OPTION I: ALL EQUITY FINANCING EBIT 50 100 Interest 0 0 EBT 50 100 Tax 40% 20 40 PAT 30 60 Nos. of shares 100 100 EPS (Rs./Share) 0.30 0.60 RoE 3.0% 6.0%

150 0 150 60 90 100 0.90 9.0%

200 0 200 80 120 100 1.20 12.0%

250 0 250 100 150 100 1.50 15.0%

OPTION II: 50% EQUITY & 50% DEBT FINANCING EBIT 50 100 150 200 Interest 50 50 50 50 EBT 0 50 100 150 Tax 40% 0 20 40 60 PAT 0 30 60 90 Nos. of shares 50 50 50 50 EPS (Rs./Share) 0.60 1.20 1.80 RoE 0.0% 6.0% 12.0% 18.0%

250 50 200 80 120 50 2.40 24.0%

EBIT-EPS Analysis
EBIT-EPS Analysis is a powerful analytical tool that helps in evaluation of different financing patterns and in establishing a target capital structure. As leverage increase the change in EPS and ROE is steeper and steeper. Therefore, increased amount of debt makes returns to shareholders higher and riskier. With EBIT-EPS analysis the capital structure can be planned with desired return on equity or EPS and risk appetite
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EBIT-EPS Equation & Limitations

The relationship between EBIT and EPS can also be explained as below: EPS = (EBIT I) ( 1-t ) / E Limitations - EBIT-EPS analysis ignores: Growth potential Risk of EBIT, and Time Value of Money
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ROI-ROE Analysis
If the EBIT is replaced by ROI and EPS by ROE and both are expressed in % terms, we obtain the same relationship like: 1. As long as ROI is greater than the cost of debt, the excess of ROI over the cost of debt contributes to enhancement of the ROE. So the capital structure should have borrowings. 2. When the ROI is not enough to meet the cost of debt, it is advantageous to have the capital structure oriented towards equity. 3. The point where ROI is equal to the cost of debt will be the point of indifference for the capital structure.
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ROI-ROE Equation
ROE = [ROI + (ROI r) D/E] (1 t)

where ROE = return on equity

ROI = return on investment

= cost of debt

D/E = debt-equity ratio t = tax rate

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LEVERAGE ANALYSIS
There are two kinds of leverage, viz., operating leverage and financial leverage. Operating leverage arises from the firms fixed operating costs. Financial leverage arises from the firms fixed financing costs.
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INCOME STATEMENT FORMAT

Sales Less: Variable costs Less: Fixed operating costs Contribution before interest and tax Less: Interest on debt Total Profit before tax leverage Less: Tax Profit after tax Less: Preferred dividend Equity earnings
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Operating leverage

Financial leverage

OPERATING LEVERAGE
The sensitivity of profit before interest and taxes (PBIT) to changes in unit sales is referred to as the degree of operating leverage (DOL). It shows the impact of Fixed cost on the earnings of the firm DOL = Contribution / Profit before interest and tax

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DOL-Effect of Change of Sales on Earnings

Firm A (Prese nt) 100* 80 NIL 20 Firm A (Futur e) 200 160 NIL 40 100% Firm B (Prese nt) 100 70 10 20 Firm B (Futur e) 200 140 10 50 100%

Sales Variable Cost Fixed Cost EBIT % change in Sales

% change in EBIT
*Figures in rupees

100%

150%
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FINANCIAL LEVERAGE
The sensitivity of profit before tax (or profit after tax or earnings per share) to changes in PBIT is referred to as the degree of financial leverage. Shows the impact of fixed cost of interest on earnings for shareholders. The % change in the EPS with 1% change in the EBIT level . The minimum value of DFL is 1.0 DFL = Profit before interest and tax / Profit before tax
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TOTAL LEVERAGE
The sensitivity of profit before tax (or profit after tax or earnings per share) to changes in unit sales is referred to as the degree of total (or combined) leverage (DTL). Shows the impact of changing level of sales on the EPS. A measure of combined risk DTL = Contribution / Profit before tax OR DTL = DOL x DFL
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Ratio Analysis
Interest Coverage Ratio = Earnings before interest and taxes / Interest on debt Cash Flow Coverage Ratio =

EBIT + Dep. + Non-cash charges

Loan repayment installment / (1 Tax rate)

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Debt Service Coverage Ratio(DSCR)

DSCR = PAT + Dep.+Yearly Int. or Lease Rent Yearly Int. or Lease Rent + Annual repayment of Principal
( Total for the given number of years have to be taken)

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CASH FLOW ANALYSIS

The key question in assessing the debt capacity of a firm is whether the probability of default associated with a certain level of debt is acceptable to the management. The cash flow analysis establishes the debt capacity by examining the probability of default.

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COMPARATIVE ANALYSIS
A common approach to analyzing the capital structure of a firm is to compare its debtequity ratio to the average debt-equity ratio of the industry to which the firm belongs. Since the firms in an industry may differ on factors like operating risk, profitability, and tax status it makes sense to control for differences in these variables.
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GUIDELINES FOR CAPITAL STRUCTURE PLANNING

Avail of the tax advantage of debt Preserve flexibility Ensure that the total risk exposure is reasonable Examine the control implications of alternative financing plans Subordinate financial policy to corporate strategy
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Beta Limited and Theta Limited operate in the same line of business of manufacture of rubber components. However their cost structures and financing structures differ substantially. An analysis of their financial performance has revealed following data: Rs Lacs Sales Beta Ltd 750 Theta Ltd 1,100

Variable Cost
Fixed Cost Operating Profit, EBIT Interest Profit Before Tax

300
250 200 75 125

500
200 400 80 320

Find out : a) Degree of Operating Leverage and Degree of Financial Leverage for both. b) What is your interpretation of DOL and DFL with an assumed 10 % increase in sales.
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Thanks

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