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Chapter-1
Capital Structure Planning & Policy

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Chapter-1
CAPITAL STRUCTURE PLANNING & POLICY

Introduction:

Capital structure refers to the mix of long-term sources of funds, such as debentures,
long-term debt, preference share capital and equity share capital including reserves and
surpluses (i.e. retained earnings). Some companies do not plan their capital structure, and
it develops as a result of the financial decisions taken by the financial manager without
any formal planning. These companies may prosper in the short-run, but ultimately they
may face considerable difficulties in raising funds to finance their activities.

With

unplanned capital structure, these companies may also fail to economize the use of their
funds. Consequently, it is being increasingly realized that a company should plan its
capital structure to maximize the use of the funds and to be able to adapt more easily to
the changing conditions.

Theoretically, the financial manager should plan an optimum capital structure for his
company. The optimum capital structure is obtained when the market value per share is
maximum. In practice, the determination of an optimum capital structure is a formidable
task, and one has to go beyond the theory. There are significant variations among
industries and among individual companies within an industry in terms of capital
structure.

Since a number of factors influence the capital structure decision of a

company, the judgment of the person making the capital structure decision plays a crucial
part. Two similar companies can have different capital structures if the decision makers
differ in their judgment of the significance of various factors. A totally theoretical model
perhaps cannot adequately handle all those factors which affect the capital structure
decision. These factors are highly psychological, complex and qualitative and do not
always follow accepted theory, since capital markets are not perfect and the decision has
to be taken under imperfect knowledge and risk. The board of directors or the chief
financial officer (CEO) of a company should develop an appropriate capital structure
which is most advantageous to the company. This can be done only when all those
analyzed and balanced. The capital structure should be planned generally keeping in

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view the interests of the equity shareholders and the financial requirements of a company.
The equity shareholders, being the owners of the company and the providers of risk
capital (equity) would be concerned about the ways of financing a companys operations.
However, the interests of other groups, such as employees, customers, creditors, society
and government, should also be given reasonable consideration.

A sound or appropriate capital structure should have the following features:

Return: The capital structure of the company should be most advantageous.

Subject to other considerations, it should generate maximum returns to the
shareholders without adding additional cost to them.
Risk: The use of excessive debt threatens the solvency of the company. To the
point debt does not add significant risk it should be sued, otherwise its use should
be avoided.
Flexibility: The capital structure should be flexible. It should be possible for a
company to adapt its capital structure with a minimum cost and delay if warranted
by a changed situation. It should also be possible for the company to provide
funds whenever needed to finance its profitable activities.
Capacity: The capital structure should be determined within the debt capacity of
the company and this capacity should not be exceeded. The debt capacity of a
company depends on its ability to generate future cash flows. It should have
enough cash to pay creditors fixed charges and principal sum.
Control: The capital structure should involve minimum risk of loss of control of
the company. The owners of closely-held companies are particularly concerned
about dilution of control.

Approaches to establish appropriate capital structure:

The capital structure will be planned initially when a company is incorporated. The
initial capital structure should be designed very carefully. The management of the
company should set a target capital structure and the subsequent financing decisions
should be made with a view to achieve the target capital structure. The financial manager

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has also to deal with an existing capital structure. The company needs funds to finance
its activities continuously. Every time when funds have to be procured, the financial
manager weighs the pros and cons of various sources of finance and selects the most
advantageous sources keeping in view the target capital structure. Thus, the capital
structure decision is a continuous one and has to be taken whenever a firm needs
additional finances.
The following are the three most common approaches to decide about a firms capital
structure:
EBIT-EPS approach for analyzing the impact of debt on EPS
Valuation approach for determining the impact of debt on the shareholders value
Cash flow approach for analyzing the firms ability to service debt

In addition to these approaches governing the capital structure decisions, many other
factors such as control, flexibility, or marketability are also considered in practice.

EBIT-EPS Approach:
The use of fixed cost sources of finance, such as debt and preference share capital to
finance the assets of the company, is known as financial leverage or trading on equity. If
the assets financed with the use of debt yield a return greater than the cost of debt, the
earning per share also increases without an increase in the owners investment. The
earnings per share also increase when the preference share capital is used to acquire
assets. But the leverage impact is more pronounced in case of debt because (i) the cost of
debits usually lower than the cost of preference share capital and (ii) the interest paid on
debt is tax deductible.

Because of its effect on the earnings per share, financial leverage is an important
consideration in planning the capital structure of a company. The companies with high
level of the earnings before interest and taxes (EBIT) can make profitable use of the high
degree of leverage to increase return on the shareholders equity. One common method

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of examining the impact of leverage is to analyze the relationship between EPS and
various possible levels of EBIT under alternative methods of financing.

Illustration:
Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary
shares of Rs.10 per share. The firm wants to raise Rs.250,000 to finance its investments
and is considering three alternative methods of financing (i) to issue 25,000 ordinary
shares at Rs.10 each, (ii) to borrow Rs.2,50,000 at 8 per cent rate of interest, (iii) to issue
2,500 preference shares of Rs.100 each at an 8 per cent rate of dividend. If the firms
earnings before interest and taxes after additional investment are Rs.3,12,500 and the tax
rate is 50 per cent, the effect on the earnings per share under the three financing
alternatives will be as follows:

Table: EPS under alternative financing favourable EBIT:

EBIT
Less: Interest
PBT
Less: Taxes
PAT
Less: Preference dividend
Earning available to ordinary shareholders
Shares outstanding
EPS

Equity
Financing
Rs.

Debt
Financing
Rs.

Preference
Financing
Rs.

3,12,500
0
3,12,500
1,56,250
1,56,250
0
1,56,250
1,25,000
1.25

3,12,550
20,000
2,92,500
1,46,250
1,46,250
0
1,46,250
1,00,000
1.46

3,12,550
0
3,12,500
1,56,250
1,56,250
20,000
1,36,250
1,00,000
1.36

The firm is able to maximize the earnings per share when it uses debt financing. Though
the rate of preference dividend is equal to the rate of interest, EPS is high in case of debt
financing because interest charges are tax deductible while preference dividends are not.
With increasing levels of EBIT, EPS will increase at a faster rate with a high degree of
leverage. However , if a company is not able to earn a rate of return on its assets higher

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than the interest rate (or the preference dividend rate), debt (or preference financing) will
have an adverse impact on EPS. Suppose the firm in illustration above has an EBIT of
Rs.75,000/- EPS under different methods will be as follows:

Table: EPS under alternative financing methods: Unfavourable EBIT:

EBIT
Less: Interest
PBT
Less: Taxes
PAT
Less: Preference dividend
Earning available to ordinary shareholders
Shares outstanding
EPS

Equity
Financing
Rs.

Debt
Financing
Rs.

Preference
Financing
Rs.

75,000
0
75,000
37,000
37,500
0
1,56,250
1,25,000
0.30

75,000
20,000
55,000
27,500
1,46,250
0
27,500
1,00,000
0.27

75,000
0
75,000
37,500
1,56,250
20,000
17,500
1,00,000
0.17

It is obvious that under Unfavourable conditions, i.e. when the rate of return on the total
assets is less than the cost of debt, the earnings per share will fall with the degree of
leverage.

Limitations of EPS as a Financing decision Criterion:

EPS is one of the most widely used measures of the companys performance in practice.
As a result of this, in choosing between debt and equity in practice, sometimes too much
attention is paid on EPS, which however, has some serious limitations as a financingdecision criterion.

The major shortcoming of the EPS as a financing-decision criterion is that it does not
consider risk; it ignores the variability about the expected value of EPS. The belief that
investors would be just concerned with the expected EPS is not well founded. Investors
in valuing the shares of the company consider both expected value and variability.

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Cost of Capital and Valuation Approach:

The cost of source of finance is the minimum return expected by its suppliers. The
expected return depends on the degree of risk assumed by investors. A high degree of
risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate of
interest is fixed and the company is legally bound to pay interest whether it makes profits
or not. For ordinary shareholders, the rate of dividends is not fixed and the board of
directors has no legal obligation to pay dividends even if the profits are made by the
company.

The loan of debt-holders is returned within a prescribed period, while

shareholders will have to share the residue only when the company is wound up. This
leads one to conclude that debt is a cheaper source of funds than equity. This is generally
the case even when taxes are not considered; the tax deductibility of interest charges
further reduces the cost of debt.

The preference share capital is also cheaper than equity capital, but not as cheap as debt.
Thus, using the component, or specific, cost of capital as a criterion for financing
decisions and ignoring risk, a firm would always like to employ debt since it is the
cheapest source of funds.

Cash flow approach:

One of the features of a sound capital structure is conservatism. Conservation does not
mean employing no debt or small amount of debt. Conservatism is related to the fixed
charges created by the use of debt or preference capital in the capital structure and the
firms ability tp generate cash to meet these fixed charges. In practice, the question of the
optimum (appropriate) debt-equity mix boils down to the firms ability to service debt
without any threat of insolvency and operating inflexibility.

A firm is considered

prudently financed if it is able to service its fixed charges under any reasonably
predictable adverse conditions.

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One important ratio which should be examined at the time of planning the capital
structure is the ratio of net cash inflows to fixed charges (debt-servicing ratio).

It

indicates the number of times the fixed financial obligations are covered by the net cash
inflows generated by the company. The greater the coverage, the greater is the amount of
debt a company can use. However, a company with a small coverage can also employ a
large amount of debt if there are not significant yearly variance in its cash inflows and a
small probability of the cash inflows being considerably less to meet fixed charges in a
given period. Thus, it is not the average cash inflows but the yearly cash inflows which
are important to determine the debt capacity of a company. Fixed financial obligations
must be met when due, not on an average or in most years but, always. This requires a
full cash flow analysis.

Components of Cash flows:

The cash flows should be analyzed over a long period of time, which can cover the
various adverse phases, for determining the firms debt policy. The cash flow analysis
can be carried out by preparing proforma cash flow statements to show the firms
financial conditions under adverse conditions such as a recession. The expected cash
flows can be categorized into three groups.

Operating cash flows

Non-operating cash flows
Financial flows

Practical considerations in determining Capital Structure:

Control
Widely-held companies
Closely-held companies
Flexibility
Loan covenants
Early repay ability
Reserve capacity
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Marketability
Market conditions
Flotation costs
Capacity of raising funds
Agency costs

In practice, it may not be possible for a company to borrow whenever it wants./ lenders
may analyze a number of characteristics of the borrower before they decide to lend.
What factors do borrowers think are considered by lenders? Borrowing firms managers
perceive the following factors in order of importance being considered by lenders:
(i)

profitability

(ii)

quality of management

(iii)

security

(iv)

liquidity

(v)

existing debt-equity ratio

(vi)

sales growth

(vii)

net worth

(viii) reserve position

(ix)

fluctuations in profits

QUESTIONS:

1. What do you understand by Capital Structure?

2. Is there any need to plan the Capital Structure? If so why?
3. How do you derive optimal Capital Structure?
4. What are the features of sound Capital Structure?
5. Describe the common approaches to decide Capital Structure.

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6. Explain EBIT-EPS approach.

7. What is the valuation approach?
8. Narrate the method of Cash flow approach.
9. Explain the components of cash flow.
10. What are the practical considerations in determining the capital structure?

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