CAPITAL STRUCTURE,EPS AND LEVERAGE

Capital Structure
Capital Structure is the mixture of long-term sources
of funds. Capital Structure is optimal when the
proportion of debt and equity maximizes the value
of the equity share of the company. However, a
company heavily funded by debt has an aggressive
capital structure and poses a greater risk to investors.
This risk, however, may be the primary source of the
firm’s growth.
 Importance of Capital Structure:

t s a s a Reflects
Ac the
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 Factors Affecting Capital Structure

1] Cash Flow Position

2] Interest Coverage Ratio
3] Control
4] Return on Investment
5] Floatation Cost
6] Flexibility
7] Stock Market Conditions
8] Tax Rate
 Optimal Capital Structure
Capital structure or combination of debt and equity that
leads to maximum value of firm.

Maximises value of company and wealth of owners.

Minimises the company’s cost of capital.

 Earnings per share or EPS
• Definition: Earnings per share or EPS is an important financial
measure, which indicates the profitability of a company. It is
calculated by dividing the company’s net income with its total
number of outstanding shares. It is a tool that market participants
use frequently to gauge the profitability of a company before buying
its shares.
 

Description: EPS is the portion of a company’s profit that is allocated to every

individual share of the stock. It is a term that is of much importance to
investors and people who trade in the stock market. The higher the earnings
per share of a company, the better is its profitability. While calculating the
EPS, it is advisable to use the weighted ratio, as the number of shares
outstanding can change over time. 
 EBIT/EPS ANALYSIS (continue)

It examines how different capital structures

affect earnings available to shareholders
(Earning Per Share).
It is the analysis of the effect of financing
alternatives on earnings per share.
 To design the capital structure of the firm in
such a way so as to minimize the cost of capital.
EBIT-EPS analysis is a method to study the
effect of leverage under alternative methods of
financing.
 CALCULATION OF EPS

EBIT : xxxxx
(-)INTERSET : xxx

=EBT : xxxxx
(-)TAX : xx

=Earning for ESH : xxxxx

(÷) No. of E.S : xxx

= EPS {Earning Per Share} xxx

The present capital structure of Gupta Co. ltd. is:
4000, 5% Debenture of Rs 100 each Rs 4,00,000
2000, 8% P. Shares of Rs 100 each Rs 2,00,000
4000, Equity shares of Rs 100 each Rs 4,00,000
Term Loan @6.35% Rs 1,00,000
The present earning of the company before interest & taxes are 10% of the invested
capital every year. The company is in need of Rs 5,00,000 for purchasing a new
equipment and it is estimated that additional investment will also produce 10% earning
before interest & taxes every year.
The company has asked your advice as to whether the requisite amount be obtained in
the form of
1. 5% Debenture 3,00,000 and remaining in 8% P. Shares
2.All equity shares of Rs 100 each to be issued at par.
3. All Debt @5%
4. 6% in Preference 2,00,000 and remaining Equity. Rs 100 each
5.1,50000 in Term loan @5%,150000 in p shares@ 7.36% and remaining in equity (Rs
100 each)
Examine the problem in all its bearing and advice firm if the Corporate tax rate is 50%.
 Problem No 2
A company is expecting EBIT of Rs. 5,00,000 per annum on investment of Rs.
10,00,000 which is in equity of Rs100/ each. (old capital)
Company is in need of another Rs. 10,00,000 for its expansion activities.
Company can raise this amount by either equity shares capital or 12%
preference share capital or 10% debentures. The company is considering the
following financing patterns:
a. 10,00,000 through issue of Equity Shares at par;
b. 5,00,000 by issue of Equity Share Capital and remaining 5,00,000 by issue
of Debentures;
c. 5,00,000 through Equity Shares and 2,50,000 through Preference Share
Capital and remaining 2,50,000 through Debentures.;
d. 5,00,000 through Debenture and 2,50,000 through Equity Shares and
remaining 2,50,000 through Preference Share Capital.

Find out the best financing mix assuming 35% tax rate
EBIT – EPS BREAK EVEN ANALYSIS:
• The EBIT level at which the EPS is the same for two alternative
financial plan is referred to as the indifference point/level.

• Financial break even point obtained by a company at a given

level of EBIT for which the firm’s EPS is zero.

• If EBIT is less than financial break even point, then the EPS is
negative.

• If EBIT is more than the financial break even point, then more
and more fixed cost financing option can be used by a firm.
 DRAWBACKS
• The EBIT-EPS approach is not always the best tool for making decisions
about capital structuring.

• The EBIT-EPS approach places heavy emphasis on maximizing earnings

per share rather than controlling costs and limiting risk.

• It's important to keep in mind that as debt financing increases, investors

should expect a higher return to account for the greater risk; this is known
as a risk premium.

• The EBIT-EPS approach does not factor this risk premium into the cost of
financing, which can have the effect of making a higher level of debt
seem more advantageous for investors than it actually is.
 LEVERAGE
Leverage is the employment of an asset/source of finance for
which firm pay fixed cost/fixed return. It may of three types:

• Operating Leverage
• Financial Leverage
• Combined Leverage
 Leverage

Operating Financial Combined

Leverage Leverage Leverage
 OPERATING LEVERAGE
• It may be defined as the firm’s ability to use fixed operating
costs to magnify the effects of changes in sales on its earnings
before interest and taxes.

• Operating leverage is associated with investment (assets

acquisition) activities.

Degree of Operating Leverage (DOL) = Contribution/EBIT

Percentage change in EBIT / Percentage change in sales
 FINANCIAL LEVERAGE
• Financial leverage is the ability of the firm to use fixed
financial charges to magnify the effects of changes in EBIT on
the firm’s earnings per share.

• Degree of financial leverage (DFL)=EBIT/EBT

Percentage change in EPS divided by Percentage change in EBT

 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 EPS % change in EPS

CL  * 
% change in sales % Change in EBIT % Change sales
• A firm has sales of Rs. 10,00,000, variable cost
of Rs. 7,00,000 and fixed costs of Rs. 2,00,000
and debt of Rs. 5,00,000 at 10% rate of
interest.
• What are the operating, financial and
combined leverages. If the firm wants to
double its earnings before interest and tax
(EBIT), how much of a rise in sales would be
needed on a percentage basis?
 Problem 3
• The balance sheet of Well Established Company is as follows:
Liabilities    Amount Assets  Amout
Equity share capital        60000Fixed Assets             150000
Retained Earning 20000Current Assets 50000
10% Long term Debt 80000   
Current Liabilities 40000   
  200000  200000

• The company’s total assets turnover ratio is 3, its fixed operating

costs are Rs.1,00,000 and its variable operating cost ratio is 40%. The
income tax rate is 50%. Calculate the different types of leverages and
EPS given that the face value of share is Rs.10.
• (Total Assets Turnover Ratio =  Sales / Total Assets)
Following is the information to three companies’ Alpha beta and
gamma. Prepare income statement of all three companies .
  Alpha Beta Gamma
Variable cost as a percentage 66 2/3 % 75% 50%
on sales

Interest Rs 200/- Rs 300/- Rs 1000/-

OL 5:1 6:1 2:1
FL 3:1 4:1 2:1
Rate of Income tax(%) 50 50 50