Capital Structure

G.VIJAYA KUMAR
Prof. NAC
  Capital Structure of a company refers to the
composition or make-up of its capitalization
and it includes all long-term capital recourses
viz:
 Loans
 Reserves

Meaning  Shares and

 Bonds
 The capital structure is made up of debt and
equity securities and refers to permanent
financing of a firm.
 It is composed of Long-term debt, Preference
share capital and Shareholders funds.
  The capital structure of a new
company may consist of any
of the following forms:
 A) Equity Share Capital only
Forms of  B) Equity and Preference
Capital Shares
Structure  C) Equity Shares and
Debentures
 D) Equity Shares , Preference
Shares and Debentures.
  Capital structure refers to the relationship
between various long-term forms of financing
such as
 Debentures, Preference Share Capital and
Equity Share Capital
 Financing the firms assets is a very crucial
Importance of problem in every business and as general rule
Capital there should be a proper mix of debt and
Structure equity capital in financing the firms assets.
 Thus the use of long-term fixed interest
bearing debt and preference share capital
along with equity shares is called Financial
leverage or Trading on equity.
 The long-term fixed interest bearing debt is
employed by a firm to earn more from the use
of these sources than their cost so as to
increase the return on owners equity.
 For example:
 Equity Share Capital : 1,000 shares of Rs.100
each fully paid and earns average profit of
Rs.30,000.
 Company wants to make expansion and needs
another Rs.1,00,000. The options are either to
issue new shares or Raise Loans @ 10% p.a.
 Assuming that the company would earn the
same rate of profits. It is advisable to raise
loans as by doing so earnings per share will
magnify.
 The company shall pay only
Rs.10,000 as interest and profit
expected shall be Rs.60,000 ( before
payment of Interest). After the
payment of interest the profits left for
equity shareholders shall be
Rs.50,000. it is 50% return on the
equity capital against 30% return .
 It will work adversely if the rate of
interest is more than the expected rate
of earnings.
  ABC Company has currently an all equity
capital structure consisting of 15,000 equity
shares of Rs.100 each. The management is
planning to raise another Rs.25 lakhs to
finance a major programme of expansion and
it is considering three alternative methods of
financing:
Illustration:1  i) To issue 25,000, equity shares of Rs.100
each.
 ii) To issue 25,000, 8% debentures of
Rs.100 each.
 iii) To issue 25,000, 8% Preference Shares
of Rs.100each

The company’s expected
earnings before interest and
taxes will be Rs.8 lakhs.
Assuming a corporate tax rate
of 50%, determine the
earnings per share (EPS) in
each alternative and comment
which alternative is best and
why?
 Alternative 1 Alternative II Alternative III
Equity Debt financing Pref. share
financing financing
EBIT 8,00,000 8,00,000 8,00,000
(-) Interest --------- 2,00,000 -------
EBT 8,00,000 6,00,000 8,00,000
Tax @ 50% 4,00,000 3,00,000 4,00,000
EAT 4,00,000 3,00,000 4,00,000
(-) Pref. Div --------- --------- 2,00,000

Solution Earnings
available to
equity Shs
4,00,000 3,00,000 2,00,000

No. of Equty 40,000 15,000 15,000

Shares
EPS 4,00,000 3,00,000 2,00,000
40,000 = 15,000 = 15,000 =
10.00 20.00 13.33
  As the earnings per share are
highest in alternative – II , i.e
debt financing, the company
should issue 25,000 8%
debentures of Rs.100 each. It
will double the earnings of the
Comments: equity shareholders without the
loss of any control over the
company.
 Higher the debt equity ratio the
greater the return for equity
stockholders.
  A ltd. Company has equity share capital of Rs.5,00,000
divided into shares of Rs.100 each. It wishes to raise
further Rs.3,00,000 for expansion cum modernization
plans. The company plans the following financing
schemes.
 A) All common stock
 B) Rs. One lakh in common stock and Rs. Two
lakhs in debt @ 10%.
 C) All debt at 10% p.a
 D) Rs. One lakh in common stock and Rs. Two
Assignment lakh in preference capital with the rate of
Problem -1 dividend at 8%.
 The Company’s existing earnings before
interest and tax (EBIT) are Rs. 1,50,000 .
The corporate rate of tax is 50% .
Determine the earnings per share (EPS) in
each plan and comment on the implications
of financial leverage.
  The EPS or point of indifference
refers to that EBIT, earnings before
interest and tax, level at which EPS
remains the same irrespective of
Point of
different alternatives of debt-equity
indifference /
mix at this level of EBIT, the rate
Range of
earnings of return on capital employed is
equal to the cost of debt and this is
also known as break even level of
EBIT for alternative financial
plans.
 The equivalency or point of indifference can be
calculated algebraically , as below:
 (X – I1) (1-T) – PD = (X-I2) (1-T) – PD
 S1 S2
 Where X = Equivalency point or Break even EBIT
Level.
 I1 = Interest under alternative Financial plan 1
 I2 = Interest under alternative Financial plan 2
 T = Tax Rate
 PD = Preference Dividend
 S1 = Number of equity shares or amount of equity
share capital under alternative 1.
 S2 = Number of equity shares or amount of equity
share capital under alternative 2.
THAN
K YOU