Capital Structure

 

Capital is the most basic requirement of any Organization; it is need right from the start of the business till the end of the same. Lack of capital or inappropriate use of capital can cause issues for the organization.

Definition of Capital Structure:

Grestenbeg – “Capital Structure of a company refers to the composition or make-up of its capitalization and it includes all long-term capital resources, like – Loans, Reserves, Shares and Bonds."

Robert Wessel – “The term capital structure is frequently used to indicate the long-term sources of funds employed in a business enterprise.”

It is important to understand that capital structure is not as same as the financial structure. Capital Structure includes only long term sources of finance, wherein financial structure also includes short-term sources of finance. In simple words, financial structure is the total of the liability side of the balance sheet.

Any Enterprise can raise funds by mainly issuing 3 types of securities – Equity Shares, Preference Share and Debentures (Loan Instruments)

The total of the above 3 securities is called as the Capital or Capitalization, the proportion or the ration in which these 3 securities are issued is called as the Capital Structure.

To easily understand the concept of capital structure we can say that the ratio between the various sources of finance of the company defines its capital structure.

Any company will have one of the following capital structures –

1.      Only Equity Share

2.      Equity Shares & Preference Shares

3.      Equity Shares & Debentures

4.      Equity Shares, Preference Shares & Debentures.

 

EBIT – EPS Analysis

This analysis is an important tool for analysing the impact of capital structure on the EPS of a Firm.

EPS = (EBIT – I) (1 – t) – PD

                           n

         

            Where, EPS = Earnings Per Share,

                        EBIT = Earnings Before Interest & Tax

                       I = Interest p.a.

                        T = Tax Rate

                        PD = Preference Dividend

                        n = No. of Equity Shares.

 

EPS can also be calculated in a tabular form as follows –

        i.            Earnings Before Interest & Tax (EBIT)                    XXX

      ii.            Less: Interest                                           XXX

    iii.            Earnings Before Tax                                     XXX

    iv.            Less: Tax @ ____%                                        XXX

      v.            Earnings After Tax                                       XXX

    vi.            Less: Preference Dividend                               XXX

  vii.            Earnings Available for Equity Shareholders             XXX

viii.            Number of Equity Shares                                XXX

    ix.            Earnings Per Share – EPS (vii /viii)                    XXX

 

Financial Break Even Point

Financial BEP is the point where EBIT is equal to the Financial Charges – Interest & Preference Dividend.

There are 2 possible cases to calculate Financial BEP

Case a) When Capital Structure consists of Only Equity Shares and Debentures

            Financial BEP = Fixed Interest Charges

Case b) When Capital Structure consists of Equity Shares, Preference Shares and Debentures

            Financial BEP = I + Dp / (1 – t)

Theories of Capital Structure

1. Net Income Approach

2. Net Operating Income Approach

3. The Traditional Approach

4. Modigliani & Miller (MM) Approach

Net Income Approach

According to this approach, a firm can minimize its WACC and increase the value of firm by using debt financing to the maximum possible extent.

This approach is based on following assumptions -

a. The cost of debt is less than the cost of equity

b. There are no Taxes

c. The risk perception of investors is not changed by the use of debt.

V = S + D

Where, V = Total market value of the firm

S = Market Value of Equity Shares

   = Earnings Available for Equity Shareholders (NI)
             Equity Capitalization Rate

D = Market Value of Debt

    = EBIT

       V

Overall Cost of Capital or WACC -

Ke = EBIT

       V

Net Operating Income Approach

This theory is suggested by Durand. It is the opposite of Net Income Approach. According to this approach, change in the capital structure of the company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. 

V = EBIT (NOI)

    Ko

EBIT = Net Operating Income or Earnings before Interest & Tax

Ko= Overall Cost of Capital

Traditional Approach

This approach is also known as Intermediate Approach, it is a co,promise between the two extremes of NI Approach and NOI Approach. The approach states that initially the value of firm can be increased by increasing the use of debt, however after a certain point the firm would lose this advantage and any additional use of debt would not result in decreasing the WACC or increasing the value of firm.

In this method the market value of firm is based on the market value of Equity and Debt. and the 

Average Cost of Capital is Earnings available for Equity Shareholders / Market Value of Firm

MM Approach

MM Approach is same as the Net Operating Income Approach if taxes are ignored. However, when taxes are assumed to exist, their approach is similar to Net Income Approach.