UM20MB551-Corporate Finance

Dr C Sivashanmugam
Department of Management Studies ( PG)
sivashanmugam@pes.edu
Unit-III-Capital Structure/ Financing
Decision
Capital Structure
Meaning- Capital Structure

Mix of long-term sources of funds.

Eg: Equity, Preference, Debt( debentures, Public deposits,

Long-term loans etc)
Capital Structure
Finance Structure Vs Capital Structure

• Finance structure is a term which includes both of long-term and

short-term sources of funds.

• Capital structure is a term confined with only long-term sources of

funds. And it excludes the short-term sources of funds.
Capital Structure
Sources of Capital/Funds:

Domestic level:
• Equity shares
• Preference shares
• Retained earning/
• Long-term loans from DFIs and banks
• Debentures
• Public Deposits
Capital Structure
International Sources

In 1993, Indian govt permitted Indian companies to

mobilize capital from foreign markets.
Four types of securities:
Foreign Currency Convertible Bonds(FCCBs)
Global Depository Receipts (GDRs)
American Depository Receipts(ADRs)
External Commercial Borrowing(ECBs)
Capital Structure
International Sources -Foreign Currency Convertible Bonds(FCCBs)

Foreign Currency Convertible Bonds (FCCBs) are issued in

accordance with the scheme and subscribed by a non-
resident in foreign currency and convertible into ordinary
share of the issuing company in any manner, either in
whole or in part on the basis of only equity related
warrants attached to debt instrument. The FCCB is
almost like the convertible debentures issued in India.
Capital Structure
International Sources-Global Depository Receipts (GDRs)

• Global Depository Receipt (GDR) is an instrument

which allows Indian Corporate, Banks, Non- banking
Financial Companies etc. to raise funds through equity
issues abroad to augment their resources for domestic
operations.
• A GDR is a dollar denominated instrument of a
company, traded in stock exchanges outside the
country of origin i.e., in European and South Asian
Markets. It represents a certain number of underlying
equity shares
Capital Structure

Why mix of different sources of funds?

Capital Structure
Possible Patterns of Capital Structure:

Equity only
Equity + Preference share capital
Equity + Debt capital
Equity+ Preference + Debt capital
 Capital Structure
Company Point of View:

Features/ sources Equity Preference Debt

Cost of Capital Cost of Equity(Ke)/ Cost of Preference Cost of Debt(Kd)

Dividend (Kp)/Pref. Dividend /Interest

Level of Cost of Very High High/ Lesser than Lesser than

Capital Equity but higher than preference
debt

Risk taking ability Very High High but lesser than minimum / almost
equity low

Status Real Shareholder but no Creditors /Lenders to

owners/shareholders voting rights the company

Legal bindings No legal binding for Some extend Very much legally
payment of Dividend bided to pay Interest
and repayment of
Capital Structure
Optimum Capital Structure:

A capital structure which maximises

shareholders value by minimizing overall cost
of capital.
 Capital Structure
Principles of sound capital structure:

1) Profitability: Maximum EPS

2) Solvency: Ability to repay the debts
3) Flexibility: Adjustability according to situation
4) Retaining Control
5) Conservatism
 Capital Structure
Factors Determining Capital Structure:

EBIT-EPS Analysis/ Trading on equity

Growth and stability of sales

Legal requirements:
(baking companies – no.debts)
Purpose of Financing:
Productive- Debt & preference
Non-Productive – No immediate returns- Equity
Capital Structure
Factors Determining Capital Structure:

Periods of Financing:
permanent- equity
Non –permanent- Debt & Preference
Market sentiments:
 Nature and size of a firm:
Requirements of Investors:
Capital appreciation, Regular Income, Both- ?
 Provision for the future:
 Capital Structure
Factors Determining Capital Structure:

Government policies:

 Capital market conditions:

Interest of Retaining Control:

closely held companies. Eg Wipro ,

Floatation cost:
Capital Structure
Calculation of EPS

Earnings Before Interest and Taxes(EBIT) XXX

Less: Interest XXX
Earnings after interest but before Taxes (EBT) XXX
Less: Taxes@30 XXX
Earnings after Interest and Taxes(EAT) XXX
Less: Preference Dividend XXX
Earnings Available to Equity shareholders XXX
(÷) Number of Equity shares XXX
Earnings per share(EPS)
 Capital Structure
Calculation of EPS

How to calculate ?
(EBIT-I)(1-T)-PD
N
EBIT-Earnings before Interest and Taxes
I- Amount of Interest
T- Tax Rate
PD- Preference Dividend
N- Number of Equity shares
Capital Structure
Interest Coverage Ratio ( ICR)

To check whether the firm is in a position to pay the interest

ICR = EBIT
Interest
Interest Coverage Ratio ( ICR)

Sum : A company is EBIT of 12 Lakhs. Its present borrowings are:

11% Term loans Rs: 40 lakhs
Working capital :
Borrowings from bank at 16% Rs:33 lakhs
Public Deposits at 12% Rs:15 lakhs
The sales of the company is growing and to support this the company
proposes to obtain an additional bank borrowing of Rs 25 lakhs. The
increase in EBIT is expected to be 20%. Calculate the change in
interest coverage ratio after the additional borrowings and comment.
Interest Coverage Ratio ( ICR)- At present level

ICR = EBIT 12,00,000 = 1.045 times

Interest 11,48,000

Calculation of interest
11% Term loans Rs: 40 lakhs= 4,40,000
Borrowings from bank at 16% Rs:33 lakhs= 5,28,000
Public Deposits at 12% Rs:15 lakhs= 1,80,000
11,48,000
Interest Coverage Ratio ( ICR)- With additional borrowings

Increased EBIT= 12,00,000+ (20% of 12,00,000)=14,40,000

Calculation of interest
11% Term loans Rs: 40 lakhs= 4,40,000
Borrowings from bank at 16% Rs:33 lakhs= 5,28,000
Public Deposits at 12% Rs:15 lakhs= 1,80,000
11,48,000
Add:Additional Bank borrowings (25,00,000X16%) 4,00,000
15,48,000
Interest Coverage Ratio ( ICR)- With Additional Borrowings

ICR = EBIT 14,40,000 = 0.93023

Interest 15,48,000

Suggestion :Not advised to borrow additional loan as the ICR goes less
than 1.
Capital Structure
Point of Indifference:

At certain point of EBIT , whatever may be the

combination of Debt and Equity mix, the EPS will
remain the same. That is the point , is called as point
of Indifference.
 Capital Structure
Calculation of Point of Indifference level of EBIT

(EBIT-I1)(1-T)-PD1 =(EBIT-I2)(1-T)-PD2
N1 N2

EBIT-Earnings before Interest and Taxes

I1- Amount of Interest in Plan 1
I2- Amount of Interest in Plan 2
T- Tax Rate
PD1- Preference Dividend
PD2- Preference Dividend
N1- Number of shares
N2- Number of shares
Calculation of Point of Indifference level of EBIT
Sum: A new project under consideration by your company
requires a capital investment of Rs150 lakhs. Interest on
term loan is 12% and tax rate is 50%. If debt-equity ratio
insisted by the financing agencies is 2:1.
Calculate the point of indifference for the project.

Plan I =Equity – Rs50 lakhs and Debt Rs100 lakhs

Plan II= 100% Equity and no Debt ( assumption)
Calculation of Point of Indifference level of EBIT

EBIT-Earnings before Interest and Taxes- X

I1- Amount of Interest in Plan 1=Rs12,00,000
I2- Amount of Interest in Plan 2= NIL
T- Tax Rate =50%
PD1- Preference Dividend=NIL
PD2- Preference Dividend=NIL
N1- Number of shares=50,00,000/100= 50, 000 shares
N2- Number of shares=1,50,00,000/100=1,50,000 shares
Calculation of Point of Indifference level of EBIT

(EBIT-I1)(1-T)-PD1 =(EBIT-I2)(1-T)-PD2
N1 N2
(X-12,00,000)(1-0.50)-0 = ( X-0)(1-.50)-0
50,000 1,50,000

.5X-6,00,000= .5X
5 15

Point of indifference level of EBIT= 18,00,000

Capital Structure
Leverage:

leverage arises from existence of fixed costs.

Types of leverages:
Operating Leverage:
Financial Leverage:
Combined leverage/ Total leverage/ composite leverage
Capital Structure
Cost Structure:

Particulars 500 Units 600 Units

Sales (20/- each ) 10,000 12,000
Less: Variable Cost( Rs:10/- per unit) 5,000 6,000
Contribution 5,000 6,000
Less: Fixed Cost 1,000 1,000
Operating Profit(EBIT)/( PBIT) 4,000 5,000
Less: Interest 1000 1000
Profits Before Tax 3000 4000

Less: Tax (50%) 1500 2000

Profits After Tax 1500 2000

(÷) No. of Equity Shares 1000 shares 1000 shares

Capital Structure
Operating Leverage:

Operating leverage arises from the firms fixed operating costs, such as
salaries, rent , depreciation, insurance, etc., When firm has fixed
operating expenses.

Operating Leverage= Contribution/PBIT

Capital Structure
Operating Leverage

• When firm has fixed operating expenses 1 percent change in sales

leads to more than 1 percent change in profit, before interest in
terms (EBIT) leads to more than 1
Capital Structure
Operating Leverage
Sum : The installed capacity of a factory 600 units. Actual capacity
used is 400 units. Selling price per unit is Rs 10., Variable cost is Rs 6 per
unit . Calculate the operating leverage in each of the following three
situations:
1.When fixed costs are Rs 400
2.When fixed costs are Rs 1000
3.When fixed costs are Rs1,200
Particulars Situation 1 Situation 2 Situation 3

Sales 4000 4,000 4,000

(400 unitsXRs10)

Less: Variable Cost 2,400 2,400 2,400

( Rs6 /- per unit)
(400unitsXRs6)
Contribution 1,600 1,600 1,600

Less Fixed Cost 400 1,000 1,200

Profit -(PBIT) 1200 600 400

Operating leverage 1,600/1,200 1,600/600=2.66:1 1,600/400=4:1

=Contribution/ PBIT
=1.33:1
Capital Structure
Financial leverage:

Financial leverage arises from firm’s fixed financial charges. Whenever

firm useses fixed interest bearing securities such as Debt and Pref.
Share Capital, financial charges arises.

Financial leverage= PBIT/PBT

Capital Structure
Financial leverage:

When the firm have fixed financial charges, 1 percent change in profit
before interest and taxes(PBIT) leads to more than 1 percent change in
Profit Before Tax(PBT or PAT or EPS).
 Capital Structure
Financial leverage
Sum: A company has a choice of the following three financial plans .
You are required to calculate the financial leverage in each case and
interpret it.
Interest @10% on debt in all cases.
 Sources X Y Z
Equity 2000 1000 3000
capital
Debt 2000 3000 1000
Operating( 400 400 400
EBIT)
Capital Structure
Financial leverage

X y Z
Equity share Capital 2,000 Equity share Capital 1000 Equity share Capital 3,000
Debt 2,000 Debt 3,000 Debt 1,000

EBIT 400 400 400

Less: Interest@10% 200 300 100
EBT 200 100 300
Financial Leverage 400/200=2:1 400/100=4:1 400/300=1.33:1
=PBIT/PBT
Capital Structure
Combined Leverage :

Combined leverage arises because of existence of fixed operating costs and

fixed financial charges.

Combined Leverage=Contribution/PBT ( or )

Combined Leverage=Operating leverage X Financial leverage

When there is total leverage, 1 percent change in revenues( sales/ contribution)

leads to more than 1 percent change in PBT or PAT or EPS.
Capital Structure
Combined Leverage :

Sum : A company has sales of Rs 1 lakh. The variable

costs are 40% of the sales while the fixed operating
costs amount to Rs 30,000. The amount of interest
on long-term debt is Rs 10,000. You are required to
calculate the composite leverage and illustrate its
impact if sales increase by 5%.
Capital Structure
Combined Leverage :
Particulars Amount ( Rs)
Sales 1,00,000
Less : Variable Cost @40% 40,000
Contribution 60,000
Less : Fixed Cost 30,000
EBIT 30,000
Less: Interest 10,000
EBT 20,000
Operating Leverage = C/EBIT= 60,000/30,000=
2:1
Financial Leverage =EBIT/EBT= 30,000/20,000=
1.5:1
Combined Leverage = C/EBT= 60,000/20,000=
3:1 ( or )
= 2X1.5=3:1
Capital Structure
Combined Leverage :
If sales increase by 5%.
Particulars Amount ( Rs)
Increased Sales 1,05,000
Less: Variable Cost @40% 42,000
Contribution 63,000
Less: Fixed Cost 30,000
EBIT 33,000
Less: Interest 10,000
EBT 23,000
Operating Leverage = C/EBIT= 63,000/33,000=1.91:1

Financial Leverage =EBIT/EBT= 33,000/23,000=1.44:1

Combined Leverage = C/EBT= 63,000/23,000=2.74:1

Capital Structure
Combined Leverage :

Sum: Calculate i)Operating leverage, ii) Financial

leverage and iii) Combined leverage from the
following data:
Sales 1,00,000 units @ Rs 2 per unit = Rs
2,00,000,variable cost per unit @ Rs 0.70 , Fixed
Cost Rs 1,00,000 ,Interest charges Rs 3,668.
 
Capital Structure
Combined Leverage :
Particulars Amount ( Rs)
Sales ( 1,00,000unit@Rs2) 2,00,000
Less: Variable Cost (1,00,000 units@0.70) 70,000
Contribution 1,30,000
Less: Fixed Cost 1,00,000
EBIT 30,000
Less: Interest 3,668
EBT 26,332
Operating Leverage = C/EBIT= 1,30,000/30,000= 4.33:1
Financial Leverage =EBIT/EBT= 30,000/26,332=1.13:1

Combined Leverage = C/EBT= 1,30,000/26,332=4.89:1

(or )
=4.33X1.13=4.89:1