Designing Capital

Structure
Presenter:
Prof. Isha Dave

N.R. Institute of Business Management

GLS Institute of Computer Technology-MBA

A host of factors, both quantitative and qualitative, including

subjective judgment of financial managers, have a bearing on

the determination of an optional capital structure of a firm.
They are not only highly complex but also conflicting in nature

and, therefore, cannot fit entirely into a theoretical framework.

Moreover, the weights assigned to various factors also vary

widely, according to conditions in the economy, the industry

and the company itself.

Therefore,

corporate

should

attempt

to

evolve

an

appropriate capital structure where cost of capital is minimum,

given the facts of a particular case.

The key factors relevant to designing an appropriate capital

structure are:
1)
2)
3)
4)
5)
6)
7)
8)
9)
10)

Profitability
Liquidity
Control
Leverage ratios in industry
Nature of industry
Consultation with investment banks/lenders
Commercial strategy
Timing
Company characteristics
Tax planning

1) Earnings Before Interest and Tax (EBIT) Earnings per Share

(EPS) Analysis
Objective of financial management is to maximize the
shareholders wealth, a corporate should carry out profitability
analysis

in

terms

of

determining

the

amount

of

EBIT

(indifference point) at which its EPS / MPS is identical under two

proposed financial plans.
In general, the higher the level of EBIT than the indifference
point and the lower the probability of its downward fluctuation,
the greater is the amount of debt that can be employed by a
corporate.

1. Profitability Aspect
2) Interest Coverage Ratio
Interest Coverage ratio (EBIT/I) can also be used to judge the
adequacy of EBIT to meet the firms obligations to pay financial
charges, interest on loan.
A higher ratio implies that the firm can go for larger
proportion of debt in its capital structure.
The ratio measures the size of the interest payments relative
to the EBIT.
The reciprocal of this Income gearing ratio (I/EBIT) measures
the proportion of EBIT devoted to interest payments.

Cash

Flow Analysis

Liquidity
One

position of a firm is analyzed by cash flow analysis.

measure relates the ratio of fixed financial charges to net

cash inflows. A firm can afford higher debt if the ratio is high.
Another

measure to determine the adequacy of cash flows to

meet the fixed obligations is Cash budget.

A

cash budget should be prepared for a range of possible cash

inflows with a probability attached to each of them.

The

still

firm can determine the level of debt it can employ and

remain

within

an

insolvency

limit

tolerable

to

the

3. Control
Lenders

have no direct voice in the management of a company.

They may, place certain restrictions in the loan agreement on the

managements activities.
So

long as there is no default in the payment of interest or the

repayment of the principal, there is little that they can do legally

against the company.
They

have very little say in the policy-decisions of the company

or in the selection of the board of directors.

Preference

shareholders do not have the right to vote for the

appointment of the board of directors.

3. Control
However,

if the company does not pay dividends on

preference shares for a certain number of years (2-year period

in India), they are given the right to attend the meetings and
participate in the voting.
In

most of the cases, they, like the creditors, do not have any

say in the selection of the management. The power to choose

the management in most cases rests with the equity-holders.
Accordingly,

if the main object of the management is to

maintain control, they will like to have a greater weightage for

debt and preference shares in additional capital requirements,

4. Leverage Ratios of Other

Firms In The Industry
Compare

with the debt-equity ratios of companies belonging to the

same industry, having a similar business risk.

Industry
This

standards provide a useful benchmark.

does not necessarily imply that the firms capital structure

planning is inappropriate. It may well be possible that other firms may

not be using appropriate debt-equity ratios.
They

may be more conservative or more aggressive risk-takers than

desired.
However,

comparison is helpful as it acts as a red signal to the

management that there may be something wrong with the debtequity mix of the company.

5. Nature of Industry
The nature of industry is one of the most important elements in

determining the degree of financial leverage a firm can carry

safely without any risk of bankruptcy.
If an industrys sales are subject to wide fluctuations, over a

business cycle, the firm should have a low degree of financial

leverage.
Such firms will already have a high operating leverage.

On the other hand, industries dealing with non-durable consumer

goods (food) or with inexpensive items (paper clips, match boxes)

or with items in habitual use (cigarettes) or all those products

5. Nature of Industry
Such industries can afford to have higher debt proportions in

capital structure as in lean years they do not run the risk of being
unable to meet their commitments.
It

may be inferred that those industries which have keen

competition among themselves should have a relatively greater
proportion of equity than debt.
For

example, in the garment industry much of the competition is

based on style. The styles being unpredictable and transitory the
profits also fluctuate accordingly.
At

the other extreme, there are public utility undertakings

involved in the production of electricity, gas, water, transportation
services or telephone services, which are relatively free from
intra-industry competition.

6. Consultation With
Investment Bankers & Lenders
Another

useful approach is to seek the opinion of investment

analysts,

institutional

investors,

investment

bankers

and

lenders.
These

analysts, having been in business for a considerable

period

of

information

time,

acquire

regarding

expertise

securities

of

and
a

have
large

access

to

number

of

companies and know how the market evaluates them.

They

are, therefore, in a better position to assess a particular

financial plan.

7. Maintaining Flexibility For

Commercial Strategy
Flexibility

refers to a firms ability to adjust its sources of funds

in either directionincrease or decreasein response to changes

in the need for funds.
That

is, the finance manager must keep himself in a situation

where he can change positions.

Therefore,

while designing the capital structure, he should not

lose sight of the future impact on the present financial plan.

8. Timing Of Issue
Frequently

very substantial savings may be obtained by

proper timing of security issues.

Thus,

the timing of the public offerings is also an important

consideration in capital structure decisions of a firm.

Public

offering should be made at a time when the state of

the economy as well as the capital market is ideal to provide

the funds.
The

monetary and fiscal policies that are pursued by the

government

are

also

important

in

this

regard.

The

government follows a cheap money policy to boost the 2014

8. Timing Of Issue
High

debentures yields are associated with relative scarcity

of debt money and low P/E ratios on shares are an indication

of the relative scarcity of equity funds.
Frequently,

therefore, the company has to decide whether

to finance initially with an equity issue and later with a debt

issue, or vice-versa.

9. Characteristics Of The Company

The

characteristics of a company in terms of size and credit

standing, among others, also play a vital role in determining the

share of debt and equity in its capital structure.
Firms

enjoying a high credit standing among investors/lenders

in the capital market are in a better position to get funds from

the sources of their choice.
If

the credit standing is poor, the firms choice of obtaining

funds is rather limited.

10. Tax Planning

The choice of an appropriate debt policy involves a trade-off
between tax benefits and the cost of financial distress.
Moreover, the management should consider the implicit cost of
the tax subsidy in using debt.

CAPITAL STRUCTURE PRACTICES IN

INDIA
Indian corporate employ substantial amount of debt in their
capital structure in terms of the debt-equity ratio as well as total
debt to total assets ratio.
Nonetheless, the foreign controlled companies in India use less
debt than the domestic companies. The dependence of the Indian
corporate sector on debt as a source of finance has over the
years declined particularly since the mid-nineties.
The corporate enterprises in India seem to prefer long-term
borrowings over short-term borrowings. Over the years, they
2018

seem to have substituted short-term debt for long-term debt. The

CAPITAL STRUCTURE PRACTICES IN

As a result of debt-dominated capital structure, the Indian

INDIA
corporates are exposed to a very high degree of total risk as
reflected in high degree of operating leverage and financial
leverage and, consequently, are subject to a high cost of
financial distress which

includes

a broad

spectrum of

problems ranging from relatively minor liquidity shortages to

extreme

cases

of

bankruptcy.

The

foreign

controlled

companies, however, are exposed to lower overall risk as well

as financial risk.
The debt service capacity of the a sizeable segment of the
corporate borrower as measured by (i) interest coverage ratio

CAPITAL STRUCTURE PRACTICES IN

INDIA
Retained earnings are the most favoured source of finance. There
is significant difference in the use of internally generated funds
by the highly profitable corporates relative to the low profitable
firms.
Loan from financial institutions and private placement of debt are
the next most widely used source of finance. The large firms are
more likely to issue bonds in the market than small corporate.
Preference shares are more likely to be used by low growth firms.
Preference shares are used more by public sectors units and low
growth corporate.

Thank You