Capital Structure

1. Capital Structure
• Meaning of Capital Structure
– The makeup of a firms capitalization
– The mix of the different sources of long term
funds in the total capital of the company
• Equity
• Preference shares
• Debentures
• Retained earnings

2. Capital Structure
• Capital Can be raised by two means
– Ownership securities
• Equity Shares
• Preference Shares
– Creditor ship Securities
• Debentures/Bonds

3. Capital Structure
• Difference between Capital Structure and
Financial Structure
– Financial structure
• It includes both the long term and short term sources
of funds
– Capital Structure
• Includes the long term sources of funds
– Capital structure is a part of financial sturcture
–

4. Capital Structure
• Pattern of Capital Structure
– All equity Shares
– Equity and Preference Shares
– Equity Shares and Debentures
– Equity Shares ,Debentures and preference shares
• In General we can say that capital structure is
the mix of DEBT and EQUITY
• So finding an optimal capital structure is
finding the right mix of Debt and Equity.Why?

5. Capital Structure
• Mix of D/E has a great impact on the Earnings
of the company
• Maximizing the Earnings is the objective of the
organization
• So the task is to find that ratio of D/E where
the EPS is maximized
–

6. Capital Structure
• How to Write the Earning Statement of the Company
• A company has following data
• Sales = Rs 1,00,000
• Cost= Rs 40,000
• Debt payment = RS 5000
• Dividend to Preference Share Holders = Rs 20,000
• No of Equity Shares = Rs 1000
• Find the EPS( Earning Per Share) for the company?

7. Earnings Statement of the COMPANY
1 Sales 1,00,000
2 Cost 40,000
3 Operating Profit (1-2)
Earning Before Interest and Tax
(EBIT)
Rs 60,000
4 Less Interest on the Debentures 5000
5 EBT (Earnings before Tax) (3-4) Rs 55000
6 Less Tax@50% 27500
7 Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
RS 27500
8 Less Dividend to Pref. Share Holders RS 20,000
9 Earnings Available to Equity Share Holders
(EATES) (7-8)
RS 7500
10 n ( No of Shares=1000) , EPS 7500/1000 = Rs 7.5

8. Capital Structure
• Let There be company having a share capital of Rs 1,00,000
divided in to the share of Rs 10 each.. Company's present EBIT
is Rs 40,000 .Tax rate is 50%.
• Find out the EPS for this company?
• The company wants to expand and this expansion requires an
investment of Rs 50,000 Suppose that company's EBIT will not
change with this new expansion. The company is considering
following expansion plans
1. Issue 5,000 equity shares of Rs 10 each
OR
Issue 5000 preference shares, interest 12%,of Rs 10 each
OR
Issue bonds of Rs 5000 of 10% interest of Face Value Rs 10
• Which proposed capital structure the company should accept if the EBIT of
the company will not change from the present value

9. OPTION 1 (All Equity)
3 (EBIT) 40,000
4 Less Interest on the Debentures NIL
5 EBT (Earnings before Tax) (3-4) 40,000
6 Less Tax@50% 20,000
7 Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
20,000
8 Less Dividend to Pref. Share Holders Nil
9 Earnings Available to Equity Share Holders (EATES)
(7-8)
20,000
10 n ( No of Shares=10000+ 5000) , EPS Rs 1.33

10. 3 (EBIT) 40,000
4 Less Interest on the Debentures NIL
5 EBT (Earnings before Tax) (3-4 40,000
6 Less Tax@50% 20,000
7 Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
20,000
8 Less Dividend to Pref. Share Holders 6000
9 Earnings Available to Equity Share Holders (EATES) (7-
8)
14000
10 n ( No of Equity Shares=10000) , EPS Rs 1.40

11. OPTION 3 Debentures
(EBIT) 40,000
Less Interest on the Debentures 5000
EBT (Earnings before Tax) (3-4 35,000
Less Tax@50% 17500
Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
17500
Less Dividend to Pref. Share Holders Nil
Earnings Available to Equity Share Holders
(EATES) (7-8)
Rs 17500
n ( No of Shares=10000) , EPS Rs 1.75

12. Present EPS With All Equity With Pref
Shares
With
Debentures
Rs 2 Rs 1.33 Rs 1.40 Rs 1.75
Reduction in the EPS is Minimum in the case of Debentures
so the Option of capital structure with Debenture is Best

13. Capital Structure
• Let There be company having a share capital of Rs 1,00,000
divided in to the share of Rs 10 each. The company wants to
expand and this expansion requires an investment of Rs
50,000. Company's present EBIT is Rs 40,000 and suppose that
company's EBIT will increase to Rs 50,000. The company is
considering following expansion plans
1. Issue 5,000 equity shares or Rs 10 each
OR
Issue 5000 preference shares, interest 12%,of Rs 10 each
OR
Issue bonds of Rs 5000 of 10% interest
• Which proposed capital structure the company should accept
on the basis of % increase in EPS criteria

14. OPTION 1 (All Equity)
(EBIT) 50,000
Less Interest on the Debentures NIL
EBT (Earnings before Tax) (3-4 50,000
Less Tax@50% 25,000
Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
25,000
Less Dividend to Pref. Share Holders Nil
Earnings Available to Equity Share Holders
(EATES) (7-8)
25,000
n ( No of Shares=10000+ 5000) , EPS Rs 1.67

15. OPTION -2 Preference Shares
(EBIT) 50,000
Less Interest on the Debentures NIL
EBT (Earnings before Tax) (3-4 50,000
Less Tax@50% 25,000
Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
25,000
Less Dividend to Pref. Share Holders 6000
Earnings Available to Equity Share Holders
(EATES) (7-8)
19000
n ( No of Equity Shares=10000) , EPS Rs 1.90

16. OPTION 3 Debentures
(EBIT) 50,000
Less Interest on the Debentures 5000
EBT (Earnings before Tax) (3-4 45,000
Less Tax@50% 22500
Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
22500
Less Dividend to Pref. Share Holders Nil
Earnings Available to Equity Share Holders
(EATES) (7-8)
Rs 22500
n ( No of Shares=10000) , EPS Rs 2.25

17. Present EPS With All Equity With Pref
Shares
With
Debentures
Rs 2 Rs 1.67 Rs 1.90 Rs 2.25
Option of capital structure with Debenture is Best

18. Capital Structure
• The company having XYZ has a capital structure as follows
1. Equity shares of Rs 100 each = Rs 20 Lakhs
2. Preference shares @9% = Rs 12 Lakhs
3. Debentures @ 7% = Rs 8 Lakhs
4. Retained Earnings = 10 Lakhs
– The company earns 12% on its capital Employed(ROCE)
– Income tax rate is 50%.
– Find the EPS for the company?

19. Capital Structure
• What will be the starting point?
• EBIT--- The first figure in the Earning Statement
• EBIT is nothing but earnings
– Compnay is earning @12% on the capital employed
• 12% of Rs 50 Lakhs = Rs 6,00,000

20. Earning Statement of Company
(EBIT) 12% on capital (50,00,000) 6,00,000
Less Interest on the Debentures 56,000
EBT (Earnings before Tax) (3-4 5,44,000
Less Tax@50% 2,72,000
Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
2,72,000
Less Dividend to Pref. Share Holders 1,08,000
Earnings Available to Equity Share Holders
(EATES) (7-8)
Rs 1,64,000
n ( No of Shares=20,000) , EPS Rs 8.20

21. Capital Structure
• The same company is thinking for an additional plant for which
it needs Rs 25 lakhs. The following alternatives are available
to the company for financing
1. Alternative 1
1. 20000 Equity shares of Rs 125.0 each
2. Alternative 2
1. Preference shares @10%
3. Alternative3
1. Debentures @ 8%
– Which Financing Option would you
recommend? The ROCE for the company
remains the same at 12%

22. Equity Option
(EBIT) 12% on capital 9,00,0000
Less Interest on the Debentures (old) 56,000
EBT (Earnings before Tax) (3-4 8,44,000
Less Tax@50% 4,22,000
Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
4,22,000
Less Dividend to Pref. Share Holders (old) 1,08,000
Earnings Available to Equity Share Holders
(EATES) (7-8)
Rs 3,14,000
n ( No of Shares=40,000) , EPS Rs 7.85

23. Preference Share Option
(EBIT) 12% on capital 9,00,0000
Less Interest on the Debentures (old) 56,000
EBT (Earnings before Tax) (3-4 8,44,000
Less Tax@50% 4,22,000
Earnings after Tax
Or
Profit After Tax (PAT) (5-6)
4,22,000
Less Dividend to Pref. Share Holders (old)
Dividend to Pref. Share Holders (New)
Total
1,08,000
2,50,000
Earnings Available to Equity Share Holders
(EATES) (7-8)
Rs 64,000
n ( No of Shares=20,000) , EPS Rs 3.20

24. Present EPS With All Equity With Pref
Shares
With
Debentures
Rs 8.20 Rs 7.85 Rs 3.20 Rs 10.70
Option of capital structure with Debenture or financing through
Debt is the Best

25. Example
A company needs Rs 60,00,000 for the installation of new factory which is
expected to earn an EBIT of Rs 10,00,000 per annum. The company has the
objective of maximizing the EPS. The company is considering the possibility
of issuing equity shares plus raising a debt of Rs 10,00,000 or Rs 30,00,000
and or Rs 50,00,000.The current market price of the share is Rs 40 per share
and will drop to Rs 25 if the borrowings exceed Rs 37,50,000.The cost of
borrowing is as under
1. Up to Rs 12,50,000 10%
2. 12,25,000 - 31,25,000 14%
3. 31,25,000 – 50,00,000 16%
Assuming the tax rate of 50% find out the EPS under each option. Which option is advisable and
why?

26. Calculating Indifference Point
EBIT X
Less Interest on Bonds I
EBT (Earnings before Tax) (3-4 X-I
Less Tax@T% T x (X-I)
Earnings after Tax
Or
Profit After Tax (PAT)
(X-I)-T(X-I) = (X-I)( 1-T)
Less Dividend to Pref. Share Holders PD
Earnings Available to Equity Share Holders
(EATES)
(X-I)( 1-T)-PD
n ( No of Shares) , EPS (X-I)( 1-T)-PD
------------------
n

27. Capital Structure
–SO One can Write EPS as follows
– EPS = (X-I)(1-T)- PD
n
Where
• X= EBIT
• I= interest paid to Debenture Holders
• T= Tax Rate
• PD= Dividend paid to Preference Share Holders
• n = No of Equity shares in the capital structure

28. Capital Structure
– Let there be 2 capital structures with EPS1 and EPS2
– Let EPS1 = EPS2 at some value of EBIT value = X
–This is called the indifference point
(X-I1)( 1-T)-PD1 = (X-I2)( 1-T)-PD2
n1 n2
Capital Structure 1 Capital Structure 1
EPS1 EPS2
(X1-I1)( 1-T)-PD1
------------------
n1
(X2-I2)( 1-T)-PD2
------------------
n2

29. Capital Structure
• Example
• The company is thinking for an additional plant for which it
needs Rs 150 lakhs. The following alternatives are available to
the company for financing
1. D/E ration of Rs 2:1,with equity financing by issuing shares
@ Rs 1000 per share
2. All equity financing of 15000 share@ RS 1000
Calculate EBIT at indifference point. Interest
rate on term loan is 12%

30. Capital Structure
(X1-I1)( 1-T)-PD1 = (X2-I2)( 1-T)-PD2
n1 n2
• Option 1= all equity with 15000 share@100
each
• Option 2 = D/E is 2:1
• Debt = Rs 100 Lakhs
• Equity = Rs 50 Lakhs ( 5000 shares of Rs 1000 each)

31. Capital Structure
– Option 1 (all equity)
• Interest = 0
• Pd = 0
• n = 15,000
– Option 2 (D/E)
• Interest = 12 Lakh
• Pd = 0
• n = 5000
(X-0)(1-.50)-0 = (X-12)(1-.50)-0
15 5
X= RS 18 Lakhs which is the EBIT at the point of
indifference

32. Capital Structure
• Example 2
• The company is thinking for an additional plant for which it
needs Rs 50 lakhs. The following alternatives are available to
the company for financing
1. Sale of debenture @ 10%
2. All equity financing of share@ RS 50
Current capital structure of the company is as follows
• 10 Lakh ordinary share and no debt
– Calculate EBIT at indifference point, tax
rate is @50%

33. Capital Structure
• Relevance of Calculations
– If expected EBIT > EBIT at indifference point Debt financing
is beneficial
– If expected EBIT < EBIT at indifference point Equity
financing is beneficial
• Next Class Theories of Capital Structure