Capital structure

Planning the capital structure & capital structure policies

Planning the capital structure

Capital structure planning aims at the maximisation of profits and wealth of shareholders, ensures the maximum value of a firm or the minimum cost of capital. It is very important for the financial manager to determine the proper mix of debt and equity of his firm. In principle, every firm aims at achieving the optimal capital structure.

Essential features of a sound capital mix

1. 2. 3. 4. 5. 6.

Maximum possible use of leverage Flexibility Undue financial risk associated with increase of debt should be avoided Use of debt should be within the capacity of the firm It should involve minimum possible risk of loss of control It must avoid undue restrictions in agreement of debt

Factors determining the capital structure

Financial leverage/Trading on equity Growth and stability of sales Cost of capital Cash flow ability to service debt Nature and size of the firm Control Flexibility Requirements of investors

Factors determining the capital structure

Capital market conditions Asset structure Purpose of financing Period of finance Costs of floatation Abilities of management Corporate tax rate Legal requirements

Pecking Order Theory

The announcement of a share issue reduces the share price because investors believe managers are more likely to issue when shares are overpriced. Firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort.

The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order Theory

Implications:

Internal equity may be better than external equity. Financial slack is valuable. If external capital is required, debt is better.

EBIT-EPS Analysis

To understand the implications of debt financing on returns to shareholders, we compare the earnings available to shareholders (EPS) with various financing alternatives. The comparison of the financing alternatives must be made at the expected value of EBIT.EBIT-EPS analysis is a powerful analytical tool that helps in evaluation of different financing patterns and in establishing a target capital structure

As leverage increase, the change in EPS and return on equity is steeper and steeper. Therefore increased amount of debt makes returns to shareholders higher and riskier. With EBIT-EPS analysis the capital structure can be planned with desired return on equity or EPS and risk appetite.

Limitations of EBIT-EPS Analysis

1. 2. 3.

Growth rate of EPS is ignored The risk of EBIT is not considered The time value of money is not considered

ROI-ROE analysis

The EBIT-EPS analysis is done with absolute numbers available, where total earnings potential is measured by EBIT and the return to shareholders is measured in terms of EPS. Often the comparison is more convenient in percentage terms. If EBIT is replaced by ROI and EPS is replaced by ROE, and both are expressed in percentage terms, we obtain a relationship between ROI and ROE similar to that between EBIT and EPS

Summary of ROI-ROE analysis

As long as ROI is greater than the cost of debt, the excess of ROI over the cost of debt contributes to enhancement of the ROE. Therefore it is more beneficial to choose a capital structure favouring leverage. When ROI is not enough to meet the cost of debt, it is advantageous to have the capital structure oriented towards equity. The point where ROI is equal to the cost of debt will be the point of indifference from the point of view of the capital structure.