DESIGNING CAPITAL

STRUCTURE
CONTENTS
2

 Introduction
 Cost Structure and Financing Structure
 Degree of Operating Leverage
 Degree of Financial Leverage
 EBIT-EPS Analysis
 ROI-ROE Analysis
 Combined/Total Leverage
 Ratios and Industry Norms for Capital
Structure
 Defining Target Capital Structure
Capital Structure & Return
3

Various theories of capital structure

with focus on the value of the firm
consider
 tax advantage,
 cost of financial distress, and
 agency cost.
Here, objective is to evaluate different
financing plans and their impact on the
shareholders’ return and risk rather
than finding an optimal structure.
Fixed And Variable Charge
4

 There are two kinds of charge on the cash flows

of the firm: Fixed and Variable.
 Fixed charge is also of two types;
 resulting from the cost structure, and
 other from the financing structure.
The Cost Structure:
 There are normally two types of costs; fixed
and variable.
The Financing Structure:
 The other fixed charge comes from the
borrowing used to fund operations.
Operating Leverage
5

Operating leverage is the study of the

impact of fixed cost on the earnings of the
firm.
Presence of fixed cost magnifies earnings
of the firm. Earnings are
 better under favourable business conditions,
and
 poorer if conditions are unfavourable.
as compared to firms with no or smaller
fixed cost.
EBIT And Cost Structure
6

  Method A Method B
Variable Cost 50% Variable Cost 33.33%
  Bad Nor Good Bad Nor Good

Sales 120 600 1080 120 600 1080

Variable 60 300 540 40 200 360

Cost
Fixed 100 100 100 200 200 200
Cost
EBIT -40 200 440 -120 200 520

% - 120%   120% -160%   160%

Change
Degree Of Operating Leverage
7

 Degree of Operating Leverage (DOL) is a

relationship between the % change in EBIT with
1% change in sales.
 The minimum value of DOL is 1.00
 Larger the Degree of Operating Leverage larger is
the change in earnings.
 This makes earnings riskier too.
 It is a measure of business risk
ΔEBIT
Degreeof Operating Leverage(DOL)= EBIT = % Changein EBIT
ΔSales % Changein Sales
Sales
Sales- VariableCost Q(P - V)
= =
Sales- VariableCost - FixedCost Q(P - V) - F
Properties Of ‘Dol’
8

 DOL always has a value in excess of 1.0. The value of 1

signifies that entire cost is variable and any change in
sales will result in an equivalent change in the earnings.
 The value of DOL is unique at each level of operation.
 At break even point the DOL is undefined.
 Negative values of DOL signify that the firm is operating
below break-even point. It does not signify inverse
relationship.
 While operating above break-even point the value of
DOL declines and approaches 1 as firm moves away from
break-even point. This is because the fixed cost per unit
becomes lesser and lesser as nos. of units increase.
Financial Leverage
9

 Financial leverage is the study of impact of

fixed cost of interest on the earnings for the
shareholders.
 Degree of Financial Leverage (DFL) is the %
change in the Earnings per Share with 1%
change in the EBIT level. The minimum value
of DFL is 1.00
ΔEPS
Degree of FinancialLeverage(DFL) = EPS = % Change in EPS
ΔEBIT % Change in EBIT
EBIT
EBIT
=
EBIT - I - Dp /(1 - T)
Break-Even Analysis
10

Break-Even Analysis – A technique for studying

the relationship among fixed costs, variable costs,
sales volume, and profits. Also called
cost/volume/profit analysis (C/V/P) analysis.

 When studying operating leverage,

“profits” refers to operating profits before
taxes (i.e., EBIT) and excludes debt
interest and dividend payments.
Break-Even Chart
11

Total Revenues
REVENUES AND COSTS

250 Profits
($ thousands)

Total Costs
175

100 Fixed Costs

Losses Variable Costs
50

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD
Break-Even (Quantity) Point
12

Break-Even Point – The sales volume required so that

total revenues and total costs are equal; may be in units
or in sales dollars.
How to find the quantity break-even point:
EBIT = P(Q) – V(Q) – FC
EBIT = Q(P – V) – FC
P = Price per unit V = Variable costs per unit
FC = Fixed costs Q = Quantity (units)
produced and sold
Financial Leverage
13

  Plan A Plan B
No Debt With Debt
  Bad Norm Good Bad Norm Good

EBIT -40 200 440 -40 200 440

Interest - - - 75 75 75
EBT -40 200 440 -115 125 365
Taxes -16 80 176 -46 50 146
40%
PAT -24 120 264 -69 75 219
# of 150 150 150 75 75 75
shares
EPS -0.16 0.80 1.76 -0.92 1.00 2.92
(Rs.)
% Change - 120%   120% -160%   160%
Degree Of Financial Leverage
14

Larger the value of DFL

greater is the change in earnings for the
shareholders, and
 greater is the risk.

DFL is a measure of financial risk.

Properties Of ‘Dfl’
15

 DFL always has a value in excess of 1.0. The value of 1

signifies that entire funding is done through equity. The
firm has no interest burden.
 The value of DFL less than 1 means the firm is unable to
meet its fixed operational cost and EBIT is negative.
 The value of DFL is unique at each level of operation
 At break even point the DFL is undefined. Financial
break even is level of EBIT enough to meet interest.
 Negative values of DFL signify that the earnings of the
firm are not enough to cover the interest cost. Negative
sign does not signify inverse relationship.
 Value of DFL declines and approaches 1 as firm moves
away from break even point.
EBIT – EPS Analysis
16

EBIT-EPS analysis is a powerful

analytical tool that helps evaluation of
different financing patterns to establish
a target capital structure.
Evaluating Different Financing Plans
17

FINANCING PLANS
All Equity A B C D E

Debt Ratio 0% 10% 30% 50% 70% 90%

Cost of the Project 1,000 1,000 1,000 1,000 1,000 1,000
Equity 1,000 900 700 500 300 100
Debt 0 100 300 500 700 900
Cost of debt 10% 10% 10% 10% 10% 10%
Return on Assets 15% 15% 15% 15% 15% 15%

EBIT 150 150 150 150 150 150

Interest 0 10 30 50 70 90
EBT 150 140 120 100 80 60
Tax 40% 60 56 48 40 32 24
PAT 90 84 72 60 48 36
Nos. of shares 100 90 70 50 30 10

EPS (Rs./Share) 0.90 0.93 1.03 1.20 1.603.60

RoE 9.0% 9.3% 10.3% 12.0% 16.0% 36.0%
Return On Equity
18

As leverage increases the change in EPS

and Return on Equity is steeper and
steeper.
Therefore increased amount of debt
makes returns to shareholders higher
and riskier.
(EBIT - I)(1 - T)
Return on Equity, RoE 
E
Business Conditions
And “Roe”
19

BUSINESS SCENARIO  Bad Fair Normal Good V Good

Investment 1,000          
Return on Assets   5% 10% 15% 20% 25%

OPTION I: ALL EQUITY FINANCING

EBIT   50 100 150 200 250
Interest   0 0 0 0 0
EBT   50 100 150 200 250
Tax 40%   20 40 60 80 100
PAT   30 60 90 120 150
Nos. of shares   100 100 100 100 100
EPS (Rs./Share)   0.30 0.60 0.90 1.20 1.50
RoE  3.0% 6.0% 9.0% 12.0% 15.0%

OPTION II: 50% EQUITY & 50% DEBT FINANCING

EBIT   50 100 150 200 250
Interest   50 50 50 50 50
EBT   0 50 100 150 200
Tax 40%   0 20 40 60 80
PAT   0 30 60 90 120
Nos. of shares   50 50 50 50 50
EPS (Rs./Share)   - 0.60 1.20 1.80 2.40
RoE  0.0% 6.0% 12.0% 18.0% 24.0%
Debt And Return On Equity
20

Return on Equity
40% (As function of debt ratio)

35%

30%
RoE (% )

25%

20%

15%

10%

5%

0%
0% 10% 30% 50% 70% 90%

Debt Ratio (%)

Debt And Return On Equity
21

Return on Equity, RoE

(EBIT- I)(1 - T)

E
 r ( E  D ) - rd xD 
  a  x (1 - T )
 E 
 D 
  ra  ( ra - rd )  x (1 - T )
 E 

 D
Return on Equity, RoE   ra  (ra - rd )  x(1 - T)
 E
 D
15%  15  (15 - 10)  x0.6
 E
D
gives 2
E
Substituting Equity With Debt
22

Substitution of equity with debt

enhances the earnings for the equity
shareholders, as cheaper debt replaces
more expensive equity.
Though the EPS for the shareholders
increases the variability of the EPS too
increases.
In effect it means that the shareholder
is exposed to greater risk as debt
substitutes more and more equity.
EBIT, EPS And DFL
23

 Increased borrowing provides a steeper

relationship between EBIT and EPS with
advantage and disadvantage of debt depending
upon the level of earning.
 Greater the earning larger is the advantage and
lesser the earning larger is the disadvantage.

Degree of FinancialLeverage(DFL)
EBIT 150
for 100% Equity Finacing = = = 1.00
EBIT - I - Dp /(1 - T) 150 - 0
EBIT 150
for 50% Equity Finacing = = = 1.50
EBIT - I - Dp /(1 - T) 150 - 50
Point Of Indifference
24

The level of earning at which the two

financing options provide same amount
of EPS for the shareholders
(EBIT* -I1)(1- T) (EBIT* -I2 )(1- T)

n1 n2
(EBIT* -0)x0.6 (EBIT* -50)x0.6
=
100 50
gives EBIT*=100
EBIT-EPS Chart
25

6
Earnings per Share ($)

5
4 Common
3
2
1

0
0 100 200 300 400 500 600 700
EBIT ($ thousands)
EBIT-EPS Chart
26

6 Debt
Earnings per Share ($)

5 Indifference point
4 between debt and Common
common stock
3
financing
2
1

0
0 100 200 300 400 500 600 700
EBIT ($ thousands)
Combined/Total Leverage
27

 Degree of Total Leverage (DTL) is the study of

impact of changing level of sales on the EPS. It is
the product of DOL and DFL. It is measure of
combined risk.
% change in EPS
DTL =
% change in Sales
% change in EPS % change in EBIT
= x
% change in EBIT % change in Sales
= DFL x DOL
Sales - Variable cost EBIT
DTL = x
EBIT EBIT- Interest
Contributi on
=
EBIT - Interest
EBIT – EPS Analysis
Limitations
28

EBIT-EPS though a powerful tool

suffers from limitations of ignoring
the
 growth potential,
 the risk of EBIT, and

 time value of money

Ratios And Norms For Capital Structure
29

The capital structure must conform to

the various norms prevailing in the
industry and financial markets.
Industry norms for the capital structure
interalia include
 Interest Cover,
 Debt Service Coverage Ratio, and
 Debt Equity Ratio.
These norms normally place a upper
limit on the amount of debt
Coverage Ratios
30

EBIT
Interest Coverage Ratio =
Interest
 To assess the recovery of principal amount the
ability of the firm to provide sufficient cover is
adjudged by the cash coverage ratio
EBIT + Depreciation + Non - Cash Expense
Cash flow Coverage =
Loan Instalment
Interest +
(1 - T)
 Cash flow approach to determining the capital
structure focuses on liquidity, solvency and
safety.
Defining Target/Optimal Capital Structure
31

Profitability
Market and Operational risks
Liquidity and Norms
Financial Flexibility & Investment
Policy
Management and Control
Quality of Asset & Security