Capital

Structure
&
Leverages
 Financial Structure

• The term financial structure refers to the left hand

side of the balance sheet as represented by “Total
Liabilities” consisting of current liabilities, long-
term debt, preference share and equity share
capital.

• It includes both short-term and long-term sources

of funds.
 Capital Structure

• Capital structure is that part of financial structure which

represents long term sources.

• Capital structure=Equity share + preference share

+debenture +long term loans
Or Total Liabilities– Current Liabilities
 Optimum capital structure

It is that capital structure at that level of debt-

equity proportion where the market value per
share is maximum and the cost of capital is
minimum.
 Patterns / Forms of Capital Structure

Complete equity share capital;

Different proportions of equity and preference
share capital;
Different proportions of equity and debenture
(debt) capital
Different proportions of equity, preference and
debenture (debt) capital
 Determinants of capital structure

• Tax Benefit.
• Flexibility.(redeemable PS & Convertible Debentures)
• Control
• Industry Pattern Ratio
• Seasonal Variation.
• Growth & Stability of Sales
• Cost of Capital
• Industry Life Cycle.
• Size of a Firm
 Determinants of capital structure

• Requirements of investors (types of investors)

• Capital Market Conditions

• Purpose of Financing

• Period of Finance.

• Legal requirements (debt- equity ratio 2:1)

• Personal Consideration (Experience Management – Debt / Inexperience

Management-Equity
 Theories of Capital Structure

• Different kinds of theories have been given by

different authors to explain the relationship
between capital structure, cost of capital and
value of the firm The important theories are:
• Net income approach
• Net operating income approach
• Traditional approach
• Modigliani and Miller Approach
LEVERAGES
 Concept

• A lever is used to magnify the effect of force applied at one point

to another point.
• Leverage is referred to as use of a lever.
• In financial word, Leverage can be defined as the influence of
fixed expenses over the operating cash flows or earnings.
• It is the firm’s ability to use fixed cost sources of funds to
increase the return to its owners.
 TYPES OF LEVERAGE

 Operating leverage
 Financial leverage
Combined leverage
 Operating leverage

• Operating leverage can be defined as change in earnings

before interest & tax (EBIT) due to change in sales.

• In other words, operating leverage is the study of the

impact of fixed cost on the earnings of the firm.

• OL= Contribution
operating profit (EBIT)

• Degree of operating leverage= %change in EBIT

% change in sales
 Financial leverage

Financial leverage is the study of the impact of fixed

cost of interest on earnings for shareholders.
In other words, the use of the fixed-charges sources of
funds, such as debt and preference capital along with
the owners’ equity in the capital structure, is
described as financial leverage or gearing or trading on
equity.
Financial Leverage = EBIT
EBT
Degree of financial leverage (DFL)= Percentage change in EPS
Percentage change in EBIT
 Combined Leverage

 The degree of combined leverage may be defined as the

percentage change in EPS due to the percentage change in
sales.
 Thus the combined leverage is:
(% Change in EBIT / % change in sales) X(% Change in EPS/ %
Change in EBIT ) = % change in EPS / % Change sales
Or Contribution / EBT (Or) FL*OL
 CASE STUDY

The capital structure of the Progressive Corporation Ltd consists of an

ordinary share capital of Rs. 10,00,000 (shares of Rs. 100 par value)
and Rs.10,00,000 of 10% debentures. The unit sales increased by 20
per cent from 1,00,000 units to 1,20,000 units, the selling price is Rs.10
per unit, variable costs amount to Rs. 6 per unit and fixed expenses
amount to Rs. 2,00,000. The income tax rate is 35 per cent.
a) You are required to calculate the following:
(i) The percentage increase in earnings per share.
(ii) The degree of financial leverage at 1,00,000 units and 1,20,000
units.
(iii) The degree of operating leverage at 1,00,000 units and 1,20,000
units.
(b) Comment on the behaviour of operating and financial leverage in
relation to increase of production from 1,00,000 to 1,20,000 units.
Determination of earnings per share (EPS)

Sales level (units) 1,00,000 1,20,000

Sales revenue 10,00,000 12,00,000
Less variable costs 6,00,000 7,20,000
Less fixed costs 2,00,000 2,00,000
EBIT 2,00,000 2,80,000
Less interest 1,00,000 1,00,000
Earnings after interest 1,00,000 1,80,000
Less taxes 3 5,000 63,000
EAT 65,000 1,17,000
Number of equity shares 10,000 10,000
EPS (EAT / No. of Equity Shares) 6.5 11.7
(l) The percentage increase per share = (11.7-6.5)/6.5 x 100 = 80 per cent.
(ii) DFL (at 1,00,000 units) = 2,00,000/1,00,000=2.0
(at 1,20,000 units) =2,80,000/1,80,000 =1.56
(iii) DOL (at 1,00,000 units) =4,00,000/ 2,00,000 =2.0
(at 1,20,000 units) = 4,80,000/2,80,000 = 1.71

(b) As a result of increase in production and sales from 1,00,000 units to

1,20,000 units, EPS has gone up by 80 per cent Moreover, there has been
a decrease in both types of leverages-operating as well as financial-
reflecting a decline in the total risk of the company.
 EBIT-EPS Analysis

• To understand the implications of the debt

financing on Return to Shareholders , we
compare the earnings available to the
shareholders (EPS) with various financing
alternatives .
• The comparison of he financing alternatives
must be made at the expected value of EBIT.
 Evaluating Different Plans
Rs. In Lakhs
Finacial Plans
All Equity A B C D E
Debt Ratio 0% 10% 30% 50% 70% 90%
Cost of Capital 1000 1000 1000 1000 1000 1000
Equity 1000 900 700 500 300 100
Debt 0 100 300 500 700 900
Cost of Debt 10% 10% 10% 10% 10% 10%
Return on Assets 15% 15% 15% 15% 15% 15%
EBIT 150 150 150 150 150 150
Interest 0 10 30 50 70 90
EBT 150 140 120 100 80 60
Tax 40 % 60 56 48 40 32 24
PAT/EAT 90 84 72 60 48 36
No. of Shares in
Lakhs 100 90 70 50 30 10
EPS(Rs. Per Share) 0.9 0.93 1.03 1.2 1.6 3.6
Return on Equity 9.00% 9.30% 10.30% 12.00% 16.00% 36.00%
• We observe that ROE increases as the Debt
increases.
• Depending upon the level of ROE desired, we
can fix the target Capital Structure.
• If the company desire ROE of 13.5 %, they
could opt for debt of 60 %.
• ROE=(EBIT-I)(1-T)
E
I- % of Debt
T- Rate of Tax/100
E-Equity