Topics 1

st
Capital Structure
EBIT EPS Analysis

2
nd
Dividend policy
Residual Dividend policy.
Stability
Dividend v/s Buyback share
Dividend v/s bonus share
Bonus share v/s stock split




Sarthak
Vyas
Cr 1
41
Capital Structure
In finance, capital structure refers to the way a corporation finances
its assets through some combination of equity, debt, or hybrid securities.
A firm's capital structure is then the composition or 'structure' of its
liabilities.
A variety of analyses are done in practice to get a handle over the capital
structure decision.
One analysis looks at how alternative capital structure influence the
earnings per share (E.P.S).
A Second analysis assesses the impact of alternative capital structures on
return on equity.
A third analysis examines the operating, financial, and total leverage and
their effects.
A fourth analysis relies on certain leverage ratios.
A fifth analysis determines the level of debt that can be serviced by the
expected cash flows of the firm.
A sixth analysis relies on what comparable firms are doing.
Cont
Admittedly, each of these analyses is incomplete and
provides a partial answer to the question :- What capital
structure maximises the value of the firm?
Nevertheless , in practice firms commonly use one or more of
these kinds of analyses along with qualitative guidelines to
address the capital structure issue.
PBIT EPS ANALYSIS
To examine the relationship between PBIT and EPS under
alternative financing plans, let us consider the following data for
XYZ limited.
Existing Cap Structure 1 million Eq shares of Rs. 10 each
Tax rate 50%

XYZ ltd plans to raise additional capital of Rs. 10 million for
financing an expansion project. In this context, it is evaluating
two alternative financing plans :
1. Issue of equity shares (1 million of 10 each)
2. Issue of debentures carrying 14% interest.

What will be EPS under two alternative for two levels of PBIT,
say Rs 4 million and Rs. 2 million?
EQUITY FINANCING DEBT FINANCING
PBIT
2,000,000
PBIT
4,000,000
PBIT
2,000,000
PBIT
4,000,000
Interest - - 1,400,000 1,400,000
PBT 2,000,000 4,000,000 600,000 2,600,000
Taxes 1,000,000 2,000,000 300,000 1,300,000
PAT 1,000,000 2,000,000 300,000 1,300,000
No of equity
shares
2,000,000 2,000,000 1,000,000 1,000,000
EPS 0.50 1.00 0.30 1.30
In general, the relationship between PBIT and EPS is as follows
EPS = (PBIT I) (1 t)
n
EPS is Earnings per share ,
PBIT is earnings before interest and taxes,
I is the interest burden,
T is the tax rate and n is the number of equity shares.

PBIT EPS chart
Analysis of Chart
The PBIT indifference point between the two alternative
plans can be obtained mathematically by solving the
following equation for PBIT
(PBIT* - I1)(1 - t)=(PBIT* - I2)(1 - t)
n1 n2

Where PBIT* is the PBIT indifference point between the two
alternative financing plans, I1 and I2 are the interest expenses
before taxes under financing plans 1 and 2, t is the income tax
rate, and n1 and n2 are number of equity shares outstanding
under financing plans 1 and 2.
Residual Dividend Policy
Companies using the residual dividend policy choose to rely on
internally generated equity to finance any new projects. As a
result, dividend payments can come out of the residual or leftover
equity only after all project capital requirements are met. These
companies usually attempt to maintain balance in
their debt/equity ratios before making any dividend distributions,
deciding on dividends only if there is enough money left over after
all operating and expansion expenses are met.

The residual-dividend model is based on three key pieces: an
investment opportunity schedule (IOS), a target capital structure
and a cost of external capital.
DIVIDEND POLICY

1. The first step in the residual dividend model to set a target
dividend payout ratio to determine the optimal capital budget.

2. Then, management must determine the equity amount needed
to finance the optimal capital budget. This should be done
primarily through retained earnings.

3. The dividends are then paid out with the leftover, or residual,
earnings. Given the use of residual earnings, the model is known
as the "residual-dividend model."

A primary advantage of the dividend-residual model is that with
capital-projects budgeting, the residual-dividend model is useful
in setting longer-term dividend policy. A significant disadvantage
is that dividends may be unstable.
The fluctuation of dividends created by the residual policy
significantly contrasts with the certainty of the dividend stability
policy. With the stability policy, quarterly dividends are set at a
fraction of yearly earnings. This policy reduces uncertainty for
investors and provides them with income
Irrespective of the long-term payout ratio followed, the fluctuations
in the year-to-year dividends may be determined by following
guidelines.

Stable dividend payout ratio
As per this policy , the percentage of earnings paid out as
dividends remains constant. As a result of dividend fluctuate in
line with earnings. It is clear that such a policy results in
transmission of variability or earnings directly to dividends. Hence
it is rarely adopted by business firms.
Stable Dividend Policy
Stable Dividends or steadily changing dividends
As per this policy, the rupee level of dividends remains stable
or gradually increases (mostly) or decreases (rarely). The
below diagram shows the behaviour of dividends per share in
response to changes in earnings per share when such a policy
is followed. Such a policy seems to be followed widely by
business
firms.


Bonus issue v/s Stock split
The par value of share is unchanged.

A part of reserves is capitalised.

The share holders propotional
ownership remains unchanged.

The book value per share, Earnings
per share, and the market price per
share declines.

The market price per share is
brought within a popular trading
range.

The par value of the share is reduced.

There is no capitalisation of
reserves.

The share holders propotional
ownership remains unchanged .

The book value per share , the
earnings per share, and the market
price per share declines .

The market price per share is
brought within a more popular trading
range.
DIVIDEND V/S SHARE BUYBACK
Dividend is a distribution of a
portion of a company's earnings,
decided by the board of directors to
its shareholders.


Share buyback means the company
buys back some of its shares
currently traded in the open market,
thus reducing the total number of
shares available to shareholders.

It helps motivate investors to buy and
hold the company's stock.

A share buyback generally boosts share
prices by reducing the number of shares
available to own.

Dividend V/s Bonus share
Dividend is a payment made by a
company out of its earnings to
investors.

Share bonus is an increase in the
amount of shares of a company with
the new shares being given to
shareholders.

Here extra cash is received.

Here extra shares are received.

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