UNIT-3 (THEORY PART)

CAPITAL STRUCTURE AND ITS THEORIES, LEVERAGE ANALYSIS

, EBIT-EPS ANALYSIS

Capital Structure means a combination of all long-term sources of finance. It

includes Equity Share Capital, Reserves and Surplus, Preference Share capital,
Loan, Debentures, and other such long-term sources of finance. A company has
to decide the proportion in which it should have its finance and outsider’s
finance, particularly debt finance. Based on the ratio of finance, WACC and
Value of a firm are affected. There are four capital structure theories: net
income, net operating income, and traditional and M&M approaches.

Capital Structure
Capital structure is the proportion of all types of capital viz. equity, debt,
preference, etc. It is synonymously used as financial leverage or financing mix.
Capital structure is also referred to as the degree of debts in the financing or
capital of a business firm.

Financial leverage is how a business firm employs borrowed money or debts. In

financial management, it is an important term, and it is a crucial decision in
business. In a company’s capital structure, broadly, there are mainly two types
of capital, i.e., Equity and Debt. Out of the two, debt is a cheaper source of
finance because the interest rate will be less than the cost of equity, and the
interest payments are a tax-deductible expense. (Also read Capital Structure
Analysis).

Capital structure or financial leverage deals with a crucial financial management

question. The question is – ‘what should be the ratio of debt and equity?
and what are the factors that affect a capital structure‘. Before scratching our
minds to find the answer to this question, we should know the objective of
doing all this. In the financial management context, any financial decision aims
to maximize the shareholder’s wealth or increase the firm’s value. The other
question that hits the mind in the first place is whether a change in the financing
mix would impact the value of the firm or not. The question is valid as some
theories believe that financial mix impacts the value and others believe it has no
connection. Sometimes, the management also uses the pecking order theory
concept for their capital structure.

How can Financial Leverage affect the Value?

One thing is sure that wherever and whatever way one sources the finance from,
it cannot change the operating income levels. Financial leverage can, at the
max, have an impact on the net income or the EPS (Earning per Share)—the
reason we are discussing later. Changing the financing mix means changing the
level of debts, and this change in levels of debt can impact the interest payable
by that firm. The decrease in interest would increase the net income and thereby
the EPS, and it is a general belief that the increase in EPS leads to a rise in the
firm’s value.

Apparently, under this view, financial leverage is a helpful tool to increase

value, but, at the same time, nothing comes without a cost. Financial leverage
increases the risk of bankruptcy. It is because the higher the level of debt, the
higher would be the fixed obligation to honor the interest payments to the debts
providers.

Net Income Approach

Durand suggested this approach, and he favored the financial leverage decision.
According to him, a change in financial leverage would lead to a change in the
cost of capital. In short, if the ratio of debt in the capital structure increases, the
weighted average cost of capital decreases, and hence the value of the firm
increases.

Net Operating Income Approach

Durand also provides this approach. It is the opposite of the Net Income
Approach if there are no taxes. This approach says that the weighted average
cost of capital remains constant. It believes in the fact that the market analyses a
firm as a whole and discounts at a particular rate that has no relation to the debt-
equity ratio. If tax information is given, it recommends that WACC reduces
with an increase in debt financing, and the firm’s value will start increasing.

Traditional Approach
This approach does not define hard and fast facts, and it says that the cost of
capital is a function of the capital structure. The unique thing about this
approach is that it believes in an optimal capital structure. Optimal capital
structure implies that the cost of capital is minimum at a particular ratio of debt
and equity, and the firm’s value is maximum.

Modigliani and Miller Approach (MM Approach)

It is a capital structure theory named after Franco Modigliani and Merton
Miller. MM theory proposed two propositions.

 Proposition I: It says that the capital structure is irrelevant to the value of

a firm. The value of two identical firms would remain the same, and
value would not affect the choice of finance adopted to finance the assets.
The value of a firm is dependent on the expected future earnings. It is
when there are no taxes.
 Proposition II: It says that the financial leverage boosts the value of a
firm and reduces WACC. It is when tax information is available.

FACTORS DETERMINING THE CAPITAL STRUCTURE

Size of Business

Smaller firms confront tremendous problems in assembling funds due to their

poor creditworthiness. Investors are reluctant to invest their money in securities
of these firms, and lenders impose highly restrictive terms on lending. In view
of this, special attention should be paid to the maneuverability principle. This is
why common stock represents a major portion of the capital in smaller
concerns. Larger concerns have to employ different types of securities to
procure the desired amount of funds at a reasonable cost because they find it
challenging to raise capital at a reasonable cost when the demand for funds is
restricted to a single source.

Form of Business Organization

The control principle should be given higher weightage in private limited

companies where ownership is closely held in a few hands. This may be less
imminent for public limited companies with numerous shareholders. In the
proprietorship or partnership form of organization, control is undoubtedly an
important consideration because control is concentrated in a proprietor or a few
partners.

Nature of Enterprise

Business enterprises that have stability in their earnings or enjoy a monopoly

regarding their products may go for debentures or preference shares since they
will have adequate profits to meet the recurring cost of interest/fixed dividend.
This is true in the case of public utility concerns. On the other hand, companies
that do not have this advantage should rely on equity share capital to a greater
extent for raising their funds. This is particularly true in the case of
manufacturing enterprises.

Stability of Earnings

With greater stability in sales and earnings, a company can insist on fixed-
obligation debt with less risk. However, a company with irregular income will
choose to avoid burdening itself with fixed charges. Such a company should
depend upon the sale of stock to raise capital.

Age of Company

Younger companies generally find it difficult to raise capital in the initial years
because of the greater uncertainty involved and the need for recognition from
fund suppliers. Therefore, it would be worthwhile for such companies to give
higher weightage to the manoeuvrability factor. In contrast, established
companies with a good earnings record are always in a comfortable position to
raise capital from various sources. The leverage principle should be insisted
upon in such concerns.

Purpose of Financing

If funds are required for directly productive purposes, the company can afford
to raise funds by issuing debentures. On the other hand, if the funds are needed
for non-productive purposes, such as providing more welfare facilities to
employees, the company should raise funds by issuing equity shares.

Market Sentiments

During times of economic boom, investors generally seek absolute safety. In

such cases, it is appropriate to raise funds by issuing debentures. During other
periods, when people are interested in earning high speculative incomes, it is
fair to raise funds by issuing equity shares.

Credit Standing

A company with a high credit standing has a greater ability to adjust sources of
funds upwards or downwards in response to major changes in the need for funds
than one with poor credit standing. In the former case, the management should
pay greater attention to the manoeuvrability factor.
Period of Finance

The period for which finance is required also affects the determination of the
capital structure of companies. In case funds are needed, say, for 5 to 10 years,
it will be appropriate to raise them by the issue of debentures. However, if the
funds are required more or less permanently, it will be applicable to raise them
by the issue of equity shares.

Tax Considerations

Existing taxation provisions make debt more advantageous than stock capital, as
interest on bonds is a tax-deductible expense, whereas dividends are subject to
tax. Considering the prevailing corporate tax rates in India, the management
may prefer to increase the degree of financial leverage by relying more on
borrowing.

Importance of Capital Structure

Finance is an essential input for any business, necessary for working capital and
permanent investments. The total funds employed in an industry are sourced
from various channels. The owners contribute a portion of the funds, while the
remainder is borrowed from individuals and institutions. Some funds are
permanently held in the business, such as share capital and reserves (owned
funds), while others are for a long period, like long-term borrowings or
debentures. Additionally, certain funds are in the form of short-term
borrowings. The overall composition of these funds constitutes the firm’s
financial structure.

Short-term funds often shift frequently, making it challenging to define the

proportion of various sources for short-term funds rigidly. Hence, a flexible
approach is necessary. In contrast, a more definite policy is typically established
for the composition of long-term funds, known as the capital structure. Key
aspects of this policy include:

 The debt-equity ratio and the dividend decision.

 Influencing the accumulation of retained earnings.
 A crucial component of long-term owned funds.
Since permanent or long-term funds often represent a substantial portion of total
funds and involve long-term policy decisions, the term “financial structure” is
often used interchangeably with the capital structure of the firm.
Corporate enterprises generally have access to specific sources of long-term
funds. The primary sources include share capital (owners’ funds) and long-term
debt, including debentures (creditors’ funds). Profits earned from operations
constitute owners’ funds, which can be either retained in the business or
distributed to shareholders as dividends. The portion of profits retained in the
company serves as a reinvestment of owners’ funds and is, therefore, another
source of long-term funds. Together, these sources form the primary
constituents of the business’s capital, constituting its capital structure.

Features of Capital Structure

Every company aims to establish an appropriate capital structure, striving to

achieve a debt-equity proportion that maximizes the market value of shares and
minimizes the cost of capital. The features of a sound and appropriate capital
structure include:

1. Profitability

The company’s capital structure should be highly advantageous within given

constraints. It should maximize the use of leverage at a minimal cost. A sound
capital structure enables the most effective utilization of leverage at the lowest
possible cost, enhancing performance and thereby maximizing earnings per
share.

2. Solvency

Excessive use of debt poses a threat to the company’s solvency. Therefore, debt
should be employed judiciously to maintain financial stability. Excessive debt
jeopardizes the company’s solvency and credit scores. Debt financing should be
limited to an extent that allows for proper repayment.

3. Flexibility

The capital structure needs to be flexible to adapt to changing conditions. The

company should be capable of adjusting its capital structure with minimal cost
and delay in response to altered situations. Additionally, it should have the
ability to provide funds promptly when necessary to finance profitable
activities. A financial manager should be capable of modifying the firm’s
capital structure with minimal expense when necessary. Therefore, the company
needs to provide funding to support its productive operations.
4. Control

The capital structure should remain the same to the extent that it results in a loss
of power within the company. The proportions of debt and equity should be
maintained in a way that ensures there is no loss of control.

5. Conservatism

A company should always stay within its debt capacity to the extent that
servicing the debt becomes challenging. The interest and principal balances
must be fulfilled as per the debt obligations. It is anticipated that future cash
flows will facilitate these payments. Cash insolvency can escalate to legal
insolvency if potential cash flows prove insufficient.

From a solvency perspective, capital structuring should be approached with

careful consideration. The company’s debt capacity, which relies on its ability
to generate future cash flows, should not be surpassed. Sufficient cash reserves
should be maintained to meet periodic fixed charges to creditors and repay the
principal sum on maturity.

These are general features of an appropriate capital structure, and specific

characteristics may vary based on the company. Furthermore, the emphasis
placed on each part may differ among companies. For instance, one company
might prioritize flexibility over control, while another might be more concerned
with solvency than other requirements. Additionally, the relative importance of
these features may change in response to evolving conditions.

Determinants of Capital Structure

The capital structure needs to be determined when a company is established,

and the initial design requires careful consideration. The management should set
a target capital structure, and subsequent financing decisions should align with
achieving this target. As a company matures and operates over the years, the
financial manager must then contend with the existing capital structure

When the company requires continuous funds to finance its activities, the
financial manager evaluates various sources of finance each time funds need to
be procured. The manager selects the most advantageous sources with the target
capital structure in mind. Consequently, the capital structure decision becomes
an ongoing process, requiring attention whenever additional finance is needed

Common factors considered when making a capital structure decision include:

Leverage or Trading on Equity

The utilization of fixed-cost sources of finance, such as debt and preference

share capital, to fund a company’s assets is termed financial leverage or trading
on equity. When assets financed by debt generate a return greater than the cost
of the debt, earnings per share can increase without an additional investment
from the owners. Similarly, using preference share capital to acquire assets can
also increase earnings per share. However, the impact of leverage is more
pronounced with debt for two main reasons:

(i) the cost of debt is typically lower than the cost of preference share capital,
and

(ii) the interest paid on debt is a deductible charge from profits when calculating
taxable income, whereas dividends on preference shares are not.

Due to its impact on earnings per share, financial leverage is crucial when
planning a company’s capital structure. Companies with high Earnings Before
Interest and Taxes (EBIT) can effectively utilize significant force to enhance
shareholders’ equity returns. An established method for assessing the influence
of leverage is to analyze the relationship between Earnings Per Share (EPS) at
various potential levels of EBIT, considering alternative financing methods.
EBIT-EPS analysis is a valuable tool for financial managers, providing insights
into managing a firm’s capital structure. Managers can evaluate the potential
fluctuations in EBIT and assess their effects on EPS across different financing
plans.

Cost of Capital

Measuring the costs of various sources of funds is a complex subject that

requires separate treatment. Undoubtedly, it is desirable to minimize the cost of
capital. Therefore, cheaper sources should be preferred, assuming all other
factors remain the same.

The cost of a source of finance represents the minimum return expected by its
suppliers. This expected return is contingent upon the degree of risk investors
assume, with shareholders carrying a higher risk level than debt holders. The
interest rate is fixed for debt holders, and the company is legally obligated to
pay interest, regardless of its profitability. The dividend rate is not set for
shareholders, and the Board of Directors has no legal obligation to distribute
dividends, even if the company has generated profits.
Debt-holders receive the repayment of their loan within a specified period,
whereas shareholders can only recover their capital when the company is
liquidated. This leads to the conclusion that debt is a more cost-effective source
of funds than equity. Additionally, the tax deductibility of interest charges
further reduces the cost of debt. While preference share capital is cheaper than
equity capital, debt is more cost-effective.

Striking the Balance: Optimizing Debt and Equity in Capital Structure for
Cost-Efficiency

To minimize the overall cost of capital, a company should leverage a substantial

debt.

However, it should be recognized that a company cannot continually minimize

its overall cost of capital by relying solely on debt. There is a threshold beyond
which debt becomes more expensive due to the heightened risk posed to both
creditors and shareholders. As the degree of leverage increases, so does the
threat to creditors, potentially leading them to demand a higher interest rate or
even refuse to provide additional loans once a specific debt level is reached.

Moreover, excessive debt introduces significant risk to shareholders,

consequently elevating the cost of equity. While up to a certain point, the
overall cost of capital decreases with the use of debt, the cost of money rises
beyond that threshold. Consequently, it becomes disadvantageous to employ
debt further. Therefore, finding the right combination of debt and equity is
essential to minimize the firm’s average cost of capital and maximize the
market value per share.

The cost of equity encompasses both the cost of issuing new shares and the cost
associated with retained earnings. Notably, the debt cost is more economical
than both equity sources. The latter is the more cost-effective option when
considering the cost between new share issues and retained earnings.

Optimal Funding Sources: Analyzing the Cost Benefits of Retained Earnings,

Debt, and Equity in Capital Structure Management

Retained earnings incur lower costs than new share issues for two main reasons.
Firstly, the company is exempt from paying personal taxes that shareholders
must pay on distributed profits. Secondly, unlike new share issues, no flotation
costs are incurred when earnings are retained. Consequently, retained earnings
are considered the more preferable and cost-efficient choice between these two
sources.
Thus, it seems reasonable for a firm to utilize a substantial amount of debt when
considering factors such as leverage and the cost of capital, provided its
earnings do not fluctuate widely. Debt can be employed to the extent where the
average cost of capital is minimized. The interplay of these two factors
establishes the upper limit for using debt. However, other considerations must
also be assessed to determine the appropriate capital structure for a company.

Theoretically, a company should strive for a balance of debt and equity that
results in the lowest possible overall cost of capital.

Cash Flow

One characteristic of a sound capital structure is conservatism, which does not

necessarily imply the absence of debt or a minimal amount of debt.
Conservatism is associated with evaluating the liability for fixed charges
resulting from using debt or preference capital in the capital structure,
considering the firm’s ability to generate cash to fulfil these fixed obligations.

The fixed charges of a company encompass interest payments, preference

dividends, and principal repayment. Fixed costs increase when a company
utilizes a substantial debt or preferred capital. When contemplating additional
debt, a company should analyze its anticipated future cash flows to ensure it can
meet these fixed charges. It is imperative to pay interest and return the principal
amount of debt, and failure to generate sufficient cash to meet these obligations
could lead to financial insolvency.

Companies anticipating significant and stable cash inflows can comfortably

incorporate substantial debt into their capital structure. However, it is somewhat
risky for companies with unpredictable or unstable cash inflows to rely on
sources of capital with fixed charges.

Control

In designing the capital structure, the existing management is sometimes

motivated to maintain control over the company. The current
management team may want to secure election to the Board of Directors and
seek to manage the company without external interference.

Ordinary shareholders possess the legal right to elect the company’s directors.
However, when the company issues new shares, there is a risk of losing control,
which is less significant for widely held companies. In such cases, claims are
widely dispersed, and most shareholders must actively participate in the
company’s management. They are primarily interested in dividends and share
price appreciation. Distributing shares widely and in small lots is an
effective strategy to mitigate the risk of loss of control.

Maintaining control becomes a more critical issue for closely held companies. A
shareholder or group could acquire a significant portion of the new shares,
thereby gaining company control. The fear of sharing power and potential
interference from others often leads closely held companies to hesitate before
going public. Companies may issue preference shares or raise debt capital to
counter the risk of losing control.

While using debt to avoid the loss of control is a common suggestion, it’s
essential to note that substantial debt comes with restrictions imposed by debt-
holders to safeguard their interests. These restrictions limit the management’s
freedom to operate the business. Excessive debt may also lead to bankruptcy,
resulting in a complete loss of control.

Flexibility

Flexibility refers to a firm’s capacity to adjust its capital structure in response to

changing conditions. A company’s capital structure is considered flexible when
it can easily modify its capitalization or sources of funds. The company should
have the ability to raise funds promptly and cost-effectively whenever necessary
to finance profitable investments. Additionally, the company should be able to
redeem its preference capital or debt as dictated by future conditions. The
financial plan of the company must exhibit flexibility, allowing for adjustments
to the composition of the capital structure. It should position itself to substitute
one form of financing for another, aiming to optimize the utilization of funds.

Size of the Company

The size of a company significantly influences its access to funds from various
sources. Small companies often face challenges in securing long-term loans, and
if they manage to obtain one, it comes with high interest rates and inconvenient
terms. The stringent covenants in loan agreements for small companies
contribute to an inflexible capital structure, limiting management’s operational
freedom. Consequently, small companies often rely on owned capital and
retained earnings for their long-term funds.

In contrast, large companies enjoy greater flexibility in shaping their capital

structure. They can secure loans on favorable terms and also issue ordinary
shares, preference shares, and debentures to the public. A company should
leverage its size advantage when planning its capital structure to make optimal
financial decisions.

Social Sciences

Marketability

Marketability, in this context, refers to the company’s ability to sell or market a

particular type of security within a specific timeframe, contingent on the
willingness of investors to purchase that security. While marketability may not
significantly impact the initial capital structure, it is crucial in determining the
suitable timing for security issuances.

Due to changing market sentiments, the market’s preference for debenture or

ordinary share issues fluctuates over time. Consequently, the company must
decide whether to raise funds through common shares or debt based on
prevailing market conditions. If the share market is depressed, the company
should refrain from issuing ordinary shares and opt for debt issuance instead. It
can wait to issue ordinary shares until the share market experiences a revival.
Conversely, successfully issuing debentures may be challenging during a boom
period in the share market. In such cases, the company should keep its debt
capacity unutilized and issue ordinary shares to raise finances.

Floatation Costs

Floatation costs are incurred when funds are raised. Generally, the cost of
floating a debt is lower than floating an equity issue. This may incentivize a
company to opt for debt rather than issuing ordinary shares. No floatation costs
are incurred when the owner’s capital is increased by retaining earnings.
Generally, floatation costs are not a highly influential factor in determining a
company’s capital structure, except in the case of small companies.

Meaning of Leverage
Leverage is used to describe the firm’s ability to use fixed cost assets or funds
to magnify the return to its owners. James van Home has defined leverage, as
“the employment of an asset or funds for which the firm pays a fixed cost or
fixed return.” In other words, Leverage is the employment of fixed assets or
funds for which a firm has to meet fixed costs or fixed rate of interest obligation
irrespective of the level of activities or the level of operating profit.

When a firm uses fixed assets, it Results in fixed operating costs. Similarly
when a firm uses those sources of finance in its capital structure on which it is
required to pay fixed cost or fixed rate of interest, it results in fixed financial
costs. Higher is the degree of leverage higher is the risk and higher is the
expected return and vice versa.

The leverage can be favourable or unfavourable as the fixed cost or return has to
be paid irrespective of the volume of sales, the amount of such cost or return has
a significant effect on the profits available for equity shareholders.

2. Concept of Leverage
The term Leverage in general refers to a relationship between two interrelated
variables. In financial analysis it represents the influence of one financial
variable over some other related financial variable. These financial variables
may be costs, output, sales revenue, earnings before interest and tax, earnings
before tax, earning per share, etc.

There are three commonly used measures of leverages in financial

analysis. These are:

(i) Operating leverage,

(ii) Financial leverage, and

(iii) Combined leverage.

(i) Operating Leverage:

Operating Leverage is defined as “the firm’s ability to use fixed operating

costs to magnify effects of changes in sales on its earnings before interest
and taxes”. In other words operating leverage is the tendency of the
operating profit to vary disproportionately with sales. It is said to exist when
a firm has to pay fixed cost regardless of volume of output or sales.

The operating leverage shows the relationship between the changes in sales
and the changes in fixed operating income. Thus, the operating leverage has
an impact mainly on fixed costs and also on variable costs and contribution.
Of course, there will be no operating leverage if there are no fixed operating
costs.

(ii) Financial Leverage:

The financial leverage is defined as the ability of a firm to use fixed

financial charges to magnify the effects of changes in operating profits, on
the firm’s earning per share. In other words, the financial leverage is the
tendency of a residual net income to vary disproportionately with operating
profit. It indicates the change that takes place in the taxable income as a
result of change in the operating income.

(iii) Combined Leverage:

The operating leverage explains the operating risk and financial leverage
explains the financial risk of the firm. However, a firm has to look into
overall risk or total risk of the firm i.e., operating risk as well as financial
risk. Hence, if we combine the operating risk and financial risk, the result is
combined leverage. Combined leverage thus expresses the relationship
between revenue on account of sales and the taxable income.

EBIT-EPS Analysis
The EBIT-EPS analysis is carried out to assess the impact of different
financial proposals on the value (EPS) of the company. Since the basic aim
of financial management is to maximise the wealth of shareholders, the
EBIT-EPS analysis is crucial in maximising the wealth of the company.

The financial proposal having the highest EPS is considered for the
execution. The different financial proposals may be the use of, only equity,
combination of equity and debt, combination of equity and preferential
capital, or any combination of equity, debt and preferential capital. EBIT-
EPS analysis shows the impact of financial leverage on the EPS of the
company under different financial proposals.

Financial Break Even Level

It is that level of EBIT at which EPS is zero and the firm is just able to meet
all fixed financial payments like interest on debt and preference dividend.
Point of Indifference

The indifference point in financial analysis refers to the level of EBIT (Earnings
Before Interest and Taxes) at which the earnings per share (EPS) under two
different financial options are equal. It's a critical point where a company is
indifferent between two financing or investment choices because they result in
the same EPS. The two options typically involve different capital structures,
such as different levels of debt or equity financing.

Here's how to interpret and make decisions based on the indifference point:

1. If Expected EBIT < Indifference Point:

 In this scenario, the company's expected EBIT (operating profit) is
lower than the indifference point.
 It implies that the company is not generating enough earnings to cover
its fixed financial costs (interest expenses) associated with either option.
 Action: It's advisable to select the option that has a lower fixed financial
burden because it reduces the risk of financial distress when EBIT is
low.
2. If Expected EBIT = Indifference Point:
 At this point, the expected EBIT is exactly equal to the indifference
point.
 It means that both financing options will result in the same EPS.
 Action: The company can choose either option since the financial
outcome (EPS) is the same under both.
3. If Expected EBIT > Indifference Point:
 When the expected EBIT exceeds the indifference point, the company is
generating sufficient earnings to cover its fixed financial costs for both
options.
  Action: In this case, it may be preferable to select the option with a
higher fixed financial burden if it provides other advantages, such as tax
benefits or strategic considerations.

The key idea behind the indifference point analysis is to determine the
level of earnings at which the financial risk associated with different
capital structures becomes inconsequential. It helps management make
informed decisions regarding financing options, considering both the
impact on EPS and financial risk.

4. Calculating the indifference point involves setting up and solving

equations that equate the EPS under different financing scenarios. The
result is the EBIT level at which the two options yield the same EPS,
making the company indifferent to choosing either option.