omprehensive Study Notes: Capital
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Structure and Leverage
Target Audience:Bachelor of Commerce ([Link]) Students
Format:Detailed, Printable PDF Guide
1. Capital Structure: Meaning and Introduction
In financial management, while "Capitalization" refers to thetotal amountof long-term funds a
company raises,Capital Structurerefers to thecompositionor mixof those funds. It
represents the proportionate relationship between different long-term sources of financing,
primarily debt (borrowed capital) and equity (owner's capital).
firm needs capital to purchase assets and fund its growth. It can raise these funds through
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various instruments:
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● quity Funds:Equity shares, Retained earnings, Preferenceshares.
● Debt Funds:Debentures, Long-term bank loans, Bonds.
he central problem of the capital structure decision is to determine the ideal ratio between
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debt and equity that minimizes the company's overall Cost of Capital and maximizes the wealth
of its shareholders.
Difference Between Financial Structure and Capital Structure
● F inancial Structure:Consists ofallsources of funds,including both long-term and
short-term liabilities. (Total Left side of the Balance Sheet).
● Capital Structure:Is a sub-part of the financialstructure. It consistsonlyof long-term
sources of funds.
2. Theories of Capital Structure
o changes in the debt-equity mix actually affect the total value of the firm? Financial experts
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have debated this for decades, leading to four major theories of capital structure.
efore exploring the theories, it is essential to understand certain standard assumptions they
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all share:
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1 here are only two sources of funds: Debt and Equity.
2. The total assets of the firm remain constant.
3. The firm has a 100% dividend payout ratio (retained earnings are zero).
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4 he operating profit (EBIT) is given and expected to remain constant.
5. The business risk is constant across all scenarios.
A. Net Income (NI) Approach
roposed byDavid Durand, the Net Income approachargues that capital structureisrelevant.
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According to this theory, a firm can increase its total value and lower its overall Weighted
Average Cost of Capital (WACC) by increasing the proportion of debt in its capital structure.
The Logic:
● D ebt is a cheaper source of finance than equity because interest is a tax-deductible
expense, and lenders require a lower return (since their risk is lower compared to
shareholders).
● The theory assumes that the Cost of Debt ($K_d$) and Cost of Equity ($K_e$) remain
constant regardless of how much debt the firm takes on.
● Therefore, injecting a higher proportion of cheaper debt will drag the overall average cost
of capital down, boosting the firm's value.
Formula for Value of Firm ($V$):
$V = S + D$$
$
Where $S$ is the Market Value of Equity, and $D$ is the Market Value of Debt.
B. Net Operating Income (NOI) Approach
lso proposed byDavid Durand, the NOI approach isthe exact opposite of the NI approach. It
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argues that the capital structure decision is totallyirrelevant. Any change in leverage (debt) will
not affect the total value of the firm or the overall cost of capital.
The Logic:
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● he overall Cost of Capital ($K_o$) remains constant for all degrees of leverage.
● The market values the firm as a whole based on its Net Operating Income (EBIT) and
business risk.
● When a firm uses more "cheap" debt, the financial risk for the equity shareholders
increases. To compensate for this higher risk, shareholders demand a higher return.
● Therefore, the Cost of Equity ($K_e$) rises proportionally to exactly offset the benefits of
the cheaper debt. The WACC remains stubbornly flat.
C. Traditional Approach
hampioned byEzra Solomon, this is a pragmatic, middle-groundapproach. It accepts that
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debt is cheaper than equity, but it rejects the idea that you can take on unlimited debt without
consequences. Capital structuredoesmatter, and thereis an optimal mix.
The Three Stages:
1. S tage 1:Introducing debt initially reduces the overallcost of capital ($K_o$) and
increases the firm's value. Shareholders don't perceive a massive increase in risk yet, so
$K_e$ stays relatively stable.
2. Stage 2:As more debt is added, it reaches an optimalpoint. The WACC bottoms out and
the firm's value peaks. Here, the rising cost of equity exactly offsets the benefit of cheap
debt.
3. Stage 3:If the firm takes on extreme debt past theoptimal point, financial risk becomes
severe. Both equity investors and lenders panic. $K_e$ spikes dramatically, and even
lenders demand higher interest ($K_d$ rises). Consequently, WACC rises, and the firm's
value falls.
D. Modigliani-Miller (MM) Hypothesis
ranco Modigliani and Merton Miller provided a robust behavioral justification for the NOI
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approach, proving it mathematically.
Proposition I (Without Taxes - 1958):
In a perfect capital market with no taxes, no transaction costs, and identical borrowing rates for
individuals and firms, capital structure is irrelevant. Two identical firms—one leveraged (with
debt) and one unleveraged (all equity)—will have the exact same market value.
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he Arbitrage Process:If the leveraged firm has ahigher value, investors will sell their
overvalued shares in the leveraged firm, borrow money personally, and buy undervalued
shares in the unleveraged firm. This buying/selling pressure will quickly bring the values of
both firms back to equality.
Proposition II (With Taxes - 1963):
M later recognized that real-world corporate taxes change the game entirely. Because
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interest payments are tax-deductible, debt provides a "Tax Shield." Therefore, the value of a
leveraged firm is equal to the value of an unleveraged firmplusthe present value of the tax
shield. In this scenario, capital structuredoesmatter,and a firm should ideally use 100% debt to
maximize the tax shield.
3. Factors Affecting Capital Structure
In the real world, finding the perfect capital structure involves balancing multiple internal and
external factors.
Internal Factors
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ost of Capital:The primary goal is to minimize theWACC. Management must compare
the after-tax cost of debt with the cost of equity.
2. R isk Profile (Business vs. Financial Risk):If a firm has high business risk (volatile sales,
high fixed operating costs like an airline), it should avoid high financial risk (debt).
Conversely, a firm with stable, predictable cash flows (like a utility company) can afford
higher debt.
3. Cash Flow Ability:A firm must have sufficient, consistentcash flow to meet fixed
interest payments and principal repayment. Debt is a strict master; defaulting leads to
bankruptcy.
4. Desire for Control:Equity shares dilute ownershipand voting rights. If existing
promoters want to retain tight control over the company, they will prefer issuing debt or
preference shares, which do not carry voting rights.
5. Trading on Equity:The practice of using fixed-costfunds (debt) to boost the return on
equity. Management must assess if the Return on Investment (ROI) is higher than the
interest rate.
External Factors
1. C apital Market Conditions (Stock Market):During abullish stock market, investors are
eager to take risks, making it easy to issue equity shares at a premium. During a bearish
market, investors prefer safety, making debt or bonds easier to issue.
2. Taxation Policy:High corporate tax rates make debtexceptionally attractive because
interest is a deductible expense, whereas dividends are paid out of post-tax profits.
3. Attitude of Lenders/Banks:If banks perceive the industryas high-risk, they will demand
stringent collateral and high interest rates, forcing the company to rely on equity.
4. Floatation Costs:The costs of issuing securities(underwriting fees, prospectus printing,
brokerage). Issuing debt usually has lower floatation costs than floating a public issue of
equity.
4. EBIT-EPS Analysis
arnings Before Interest and Taxes (EBIT)toEarningsPer Share (EPS)analysis is a vital tool
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used by financial managers to evaluate alternative capital structures. It shows how changes in
operating profits (EBIT) impact the earnings available to equity shareholders (EPS) under
different financing plans.
he core objective is to select the financial plan that yields the highest EPS for a given,
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expected level of EBIT.
The Indifference Point
he indifference point is the specific level of EBIT at which the EPS is identical under two
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different financial plans. At this exact operating profit, it does not matter which capital
structure the firm chooses.
● If the expected EBIT isabovethe indifference point,the plan withmore debtwill yield a
igher EPS (positive trading on equity).
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If the expected EBIT isbelowthe indifference point,the plan withmore equitywill yield a
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higher EPS.
Formula for Indifference Point:
To find the indifference EBIT between Plan 1 and Plan 2, equate their EPS formulas:
$\frac{(EBIT - I_1)(1 - t) - PD_1}{N_1} = \frac{(EBIT - I_2)(1 - t) - PD_2}{N_2}$$
$
Where:
● I$ = Interest under the plan
$
● $t$ = Corporate Tax Rate
● $PD$ = Preference Dividend under the plan
● $N$ = Number of Equity Shares
Example of EBIT-EPS Analysis
ABC Ltd. requires ₹10,00,000 for expansion. It has two financing plans:
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● lan A:Issue 1,00,000 Equity Shares of ₹10 each.(Zero Debt)
● Plan B:Issue 50,000 Equity Shares of ₹10 each, andraise ₹5,00,000 through 10%
Debentures. (50% Debt)
Assume the corporate tax rate is 30%, and the expected EBIT is ₹2,00,000.
Calculation:
Particulars Plan A (100% Equity) Plan B (50% Debt)
EBIT ₹ 2,00,000 ₹ 2,00,000
Less: Interest - (₹ 50,000)
EBT (Earnings Before Tax) ₹ 2,00,000 ₹ 1,50,000
Less: Tax @ 30% (₹ 60,000) (₹ 45,000)
EAT (Earnings After Tax) ₹ 1,40,000 ₹ 1,05,000
No. of Equity Shares 1,00,000 50,000
EPS (EAT / No. of shares) ₹ 1.40 ₹ 2.10
onclusion:Because the firm is earning a healthyEBIT, the use of debt in Plan B magnifies the
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returns for the shareholders, resulting in a higher EPS (₹2.10 vs ₹1.40).
5. Optimum Capital Structure
Meaning
n optimum capital structure is the specific mix of debt and equity that maximizes the market
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value of the firm's shares while simultaneously minimizing the firm's overall weighted average
cost of capital (WACC). It is the financial "sweet spot" where the tax benefits of debt are
perfectly balanced against the risks of bankruptcy.
Characteristics of an Optimum Capital Structure
A well-designed capital structure should possess the following attributes:
1. S implicity:It should be easy for investors to understand.An overly complex structure
with multiple classes of shares, convertible bonds, and derivatives can confuse the
market and depress the share price.
2. Flexibility:The structure must allow the firm toadapt to changing conditions. The
company should be able to raise additional capital when needed without violating
existing loan covenants, and it should be able to retire debt easily if it has surplus cash.
3. Economy:The overall cost of capital must be minimized.This usually dictates the
inclusion of a healthy proportion of tax-deductible debt.
4. Profitability (Trading on Equity):The structure shouldleverage fixed-cost funds to
magnify the EPS for equity shareholders, provided the return on assets exceeds the cost
of debt.
5. Solvency and Liquidity:The use of debt should bestrictly kept within safe limits. The
firm must never struggle to pay its periodic interest or principal amounts. Bankruptcy risk
must be kept negligible.
6. Control:The capital structure should not lead tothe dilution of control for the founding
promoters. Debt and preference shares help retain control, whereas issuing new equity
dilutes it.
6. Concept and Computation of Leverages
In physics, a lever helps lift a heavy object with minimal force. In financial management,
Leveragerefers to the use of fixed-cost assets orfixed-cost funds to magnify the returns to
the owners. Leverage represents the relationship between two financial variables.
There are three types of leverage: Operating, Financial, and Combined.
A. Operating Leverage
perating leverage relates to the operational side of the business (the top half of the Income
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Statement). It occurs when a firm has highfixed operatingcosts(e.g., factory rent, machinery
depreciation, permanent salaries).
hen fixed costs are high, a small percentage change in Sales revenue will lead to a much
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larger percentage change in operating profit (EBIT).
● F ormula:
$$Operating\ Leverage\ (OL) = \frac{Contribution}{EBIT}$$
(Note: Contribution = Sales - Variable Costs. EBIT = Contribution - Fixed Costs)
● Implication:High operating leverage means high BusinessRisk. If sales drop slightly,
profits will plummet rapidly because the fixed costs must still be paid.
B. Financial Leverage
inancial leverage relates to the financing side of the business (the bottom half of the Income
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Statement). It occurs when a firm usesfixed financialcosts(e.g., interest on debt, preference
dividends).
It measures how a percentage change in operating profit (EBIT) causes a magnified percentage
change in Earnings Per Share (EPS).
● F ormula:
$$Financial\ Leverage\ (FL) = \frac{EBIT}{EBT}$$
(Note: EBT = Earnings Before Tax, which is EBIT - Interest)
● Implication:High financial leverage indicates highFinancial Risk. It signifies aggressive
"Trading on Equity." As long as EBIT is high, EPS will skyrocket. But if EBIT falls below the
interest obligations, the firm faces insolvency.
C. Combined Leverage
ombined Leverage measures the total risk of the firm by combining both business risk and
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financial risk. It shows the total impact of a change in Sales on the final EPS.
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ormula:
$$Combined\ Leverage\ (CL) = OL \times FL$$
Or:
$$Combined\ Leverage = \frac{Contribution}{EBT}$$
Example of Computing Leverages
A manufacturing company has the following data:
● ales: 10,000 units @ ₹50 per unit (Total Sales = ₹5,00,000)
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● Variable Cost: ₹30 per unit (Total VC = ₹3,00,000)
● Fixed Operating Costs: ₹1,00,000
● Interest on Debt: ₹40,000
Step 1: Prepare Income Statement
● ales: ₹5,00,000
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● Less: Variable Cost:₹3,00,000
● Contribution:₹2,00,000
● Less: Fixed Cost:₹1,00,000
● EBIT:₹1,00,000
● Less: Interest:₹40,000
● EBT:₹60,000
Step 2: Calculate Leverages
1. O perating Leverage (OL):Contribution / EBIT = 2,00,000/ 1,00,000 =2.0
(Meaning: A 10% increase in sales will result in a 20% increase in EBIT).
2. Financial Leverage (FL):EBIT / EBT = 1,00,000 / 60,000=1.67
(Meaning: A 10% increase in EBIT will result in a 16.7% increase in EPS).
3. Combined Leverage (CL):OL × FL = 2.0 × 1.67 =3.34
(Meaning: A 10% increase in sales will result in a massive 33.4% increase in the final EPS).
7. Capital Gearing
Concept
apital Gearingis an extension of capital structureanalysis. It focuses specifically on the ratio
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between funds bearing fixed interest/dividend charges (Debentures, Bank Loans, Preference
Shares) and the equity funds (Equity Share Capital + Reserves & Surplus).
It is essentially another way to evaluate financial leverage, but viewed purely through the lens
of the balance sheet.
Types of Capital Gearing
1. H ighly Geared (High Gearing):A company is said to be highly geared when the
proportion of fixed-cost capital is considerablyhigherthan the equity capital.
○ Example:Debt = ₹70 Lakhs, Equity = ₹30 Lakhs.
○ Effect:High risk. In bad times, the heavy interestburden can crush the company. In
good times, equity shareholders reap massive rewards.
2. Lowly Geared (Low Gearing):A company is lowly gearedwhen the proportion of equity
capital ishigherthan the fixed-cost capital.
○ Example:Debt = ₹20 Lakhs, Equity = ₹80 Lakhs.
○ Effect:Safe and conservative. The risk of bankruptcyis negligible, but equity
shareholders will not experience rapid, magnified growth in their EPS.
Importance and Significance of Capital Gearing
nderstanding whether a company is highly or lowly geared is crucial for management and
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investors alike:
● M agnification of Dividends:A highly geared companyhas a small equity base. Once
fixed interest is paid, the remaining profit is distributed among a small number of shares,
leading to very high dividend rates during boom periods.
● Economic Cycle Preparedness:* During an economicboom, high gearing is ideal. Sales
are rising, and the fixed interest costs remain static, generating huge surpluses for equity
owners.
○ During an economic depression, low gearing is vital. Falling sales can quickly wipe
out operating profit, making it impossible to pay fixed interest in a highly geared
firm.
● Impact on Share Price:Due to the massive fluctuationsin EPS associated with high
gearing, the market price of shares of highly geared companies is highly volatile and
speculative. Lowly geared company shares are generally more stable and favored by
conservative, long-term investors.
● Strategic Expansion:A newly formed company should ideally start with low gearing
because its profits are uncertain. As the company matures, stabilizes its cash flows, and
builds a market presence, it can gradually shift towards higher gearing to fund large
expansions without diluting control.