Capital Structure Theories 5 Viva

^Capital Structure
Theories^
Professor & Lawyer
PUTTU GURU PRASAD
Chapter – 9. Topic – 5
Business Finance
Financial Management
PLUS 2 /CBSE
VIVA the School by VVIT
5. CAPITAL STRUCTURE THEORIES
 As the financial leverage increases, the cost of
funds declines because of the increased use of
cheaper debt but the financial risk increases.
 The impact of financial leverage on the profitability of
a business can be seen through EBITEPS 3 Situation
of Company X
 (Earning before Interest and Taxes- Earning per Share)
analysis as in the following example.
EPS = (EBIT-I)(I-t)-PD
n
Where :
EPS = earning per share
EBIT = earning before int. and tax
I = int. charged per annum
t= tax rate
PD = preference dividend
n = no. of equity shares
theories of Capital structure
1 . Net Income (NI) Theory-
“David Durand” – Situation -1- Company X
2 . Net Operating Income (NOI) Theory- “David Durand”
– Situation – 2-Company X
3. Traditional Theory-
“Ezra Solomon.” – Situation – 3-Company X
4. Modigliani-Miller (M-M-Hypothesis) - by “Franco
Modigliani and Merton Miller».
Situation-Company Y- Dividend Irrelevance Theory
Example 1 Company X Ltd
Total Funds used( Equity + Debt Capital) Total Investment Rs. 30 Lakh
Interest rate ( 10% = 0.83 Paisa, less than one rupee interest) Bank Interest @10% p.a.
Tax rate (Income tax payable to the Govt) Income Tax @ 30% on Profits
EBIT (Profit before Interest and Tax) Profit earned Rs. 4 Lakh
Debt (Barrowed Funds) APPLY the 3 Situations
Situation I - 100% Own Funds (30 Lakhs) (Pattern of Investment) 1- Own Capital 30 Lakhs
Situation II- 33% Barrowed funds and 67% own funds (POI) 2- LOAN-Rs. 10 Lakh/ Own 20 Lakhs
Situation III- 67% Barrowed funds and 33% own funds(POI) 3- LOAN-Rs. 20 Lakh/ Own 10 Lakhs
EBIT-EPS Analysis Situation I (own Capital) Situation II (Loan 10L) Situation III (Loan 20L)
EBIT 4,00,000 (Profit) 4,00,000 (Profit) 4,00,000 (Profit)
Interest 10% NIL 1,00,000 (Interest) 2,00,000 (Interest)
EBT(Earnings before taxes) 4,00,000 3,00,000 (After Interest) 2,00,000 (After Interest)
Corporate Tax 30% 1,20,000 90,000 60,000
EAT (Earnings after taxes) 2,80,000 2,10,000 1,40,000
No. of shares of Rs.10 3,00,000 (0:1)D/E 2,00,000 (1:2) D/E 1,00,000 (2:1) D/E
EPS (Earnings per share) 0.93 1.05 1.40
• Three situations are considered. There is no debt in
situation-I i.e. (unlevered business).
• Debt of Rs. 10 lakh and 20 lakh are assumed in situations-II
and III, respectively. All debt is at 10% p.a.
• The company earns Rs. 0.93 per share if it is unlevered. The
cost of Debt is 10%
• With debt of Rs. 10 lakh its EPS is Rs. 1.05.
• With a still higher debt of Rs. 20 lakh, its, EPS rises to Rs.
1.40.
• Why is the EPS rising with higher debt?
• It is because the cost of debt is lower than the return
(PROFITS) that company is earning on funds
employed.
• The company is earning a return on investment (ROI)
of 13.33% (EBIT/TOTAL INVESTMENT*100)=
(4LAKHS/30LAKHS*100)
•This is higher than the 10% interest it is
paying on debt funds.
• With higher use of debt, this difference

between ROI and Cost of debt increases the
EPS.
• This is a situation of favorable financial leverage.
• In such cases, companies often employ more of
cheaper debt to enhance the EPS.
• Such practice is called Trading on Equity.
5. CAPITAL STRUCTURE THEORIES – TRADING ON EQUITY
• Trading on Equity refers to the increase in profit earned by the

equity shareholders due to the presence of fixed financial
charges like interest. Now consider the following Case of
Company Y.
• All details are the same except that the company is earning
a profit before interest and taxes of Rs. 2 lakh.
• In the following example, the EPS of the company is falling
with increased use of debt.
COMPANY Y
Total Funds Used Rs. 30 Lakhs
Interest Rate 10% Per Annum
Tax Rate 30%
EBIT Rs. 2,00,000
DEBT Component See the Table
Situation I NIL- Own Capital
Situation II Rs. 10 Lakhs
Situation III Rs. 20 Lakhs
5. CAPITAL STRUCTURE THEORIES – TRADING ON EQUITY
Example II-Company Y Situation I (Own Capital) Situation II (Loan 10L) Situation III (Loan 20L)
EBIT (PROFIT) 2,00,000 2,00,000 2,00,000
Interest-10% NIL 1,00,000 2,00,000

EBT 2,00,000 1,00,000 NIL
TAX- 30% 60,000 30,000 NIL

EAT 1,40,000 70,000 NIL
No. of shares of Rs.10 3,00,000 (0:1)D/E Ratio 2,00,000 (1:2) D/E Ratio 1,00,000 (2:1) D/E Ratio
EPS 0.47 0.35 NIL
It is because the Company’s rate of return on investment (ROI) is less than the cost of debt.
Because in the above case, the profits are only 2 lakhs, and ROI is 0.47 paisa per share. But
where as the company is paying 0.83 paisa as the interest to the barrowed funds. So Trading
on Equity by the company results in less rate of return. In this type of situations the
management should not depend on the barrowed funds. According to Capital Structure
Theories it is always advisable that, Trading on Equity can be possible only when the Cost of
Debt is less than the ROI.
The ROI of the company Y is 2 Lakhs/30 Lakhs*100 i.e. 6.67%. whereas the
interest rate on debt is 10%. In such cases, use of debt reduces the EPS.
This is a situation of unfavorable financial leverage. Trading on
Equity is clearly unadvisable in such a situation.
Even in case of Company X, reckless use of Trading on Equity is not
recommended. An increase in debt may enhance the EPS but as
pointed out earlier, it also raises the financial risk.
Ideally, a company must choose that risk-return combination which
maximizes shareholders wealth. The debt-equity mix that achieves
it, is the optimum capital structure
14 Factors Affecting the
Choice of Capital
Structure in the
Business
Factors affecting the Choice of Capital Structure
Deciding about the capital structure of a firm involves determining

the relative proportion of various types of funds. This depends on
various factors.
For example, debt requires regular servicing. Interest payment and
repayment of principal are obligatory on a business.
In addition a company planning to raise debt must have sufficient
cash to meet the increased outflows because of higher debt.
Similarly, important factors which determine the choice of capital
structure are as follows:
1.Cash Flow Position: Size of projected cash flows must be

considered before issuing debt. Cash flows must not only cover fixed
cash payment obligations but there must be sufficient buffer also.
It must be kept in mind that a company has cash payment
obligations for
(I) normal business operations;
(ii) for investment in fixed assets; and
(iii) for meeting the debt service commitments i.e.,
payment of interest and repayment of principal.
2. Interest Coverage Ratio (ICR): The interest coverage ratio refers
to the number of times earnings before interest and taxes of a
company covers the interest obligation.
This may be calculated as follows: ICR = EBIT/ Interest.
The higher the ratio, lower is the risk of company failing to meet its
interest payment obligations.
However, this ratio is not an adequate measure. A firm may have a
high EBIT but low cash balance. Apart from interest, repayment
obligations are also relevant.
3. Debt Service Coverage Ratio (DSCR): Debt Service Coverage

Ratio takes care of the deficiencies referred to in the Interest
Coverage Ratio (ICR).
It is calculated as follows: A higher DSCR indicates better ability to
meet cash commitments and consequently, the company’s potential
to increase debt component in its capital structure.
4. Cost of debt: A firm’s ability to borrow at a lower rate increases
its capacity to employ higher debt. Thus, more debt can be used if
debt can be raised at a lower rate.
5. Return on Investment (ROI): If the ROI of the company is higher, it can
choose to use trading on equity to increase its EPS, i.e., its ability to use
debt is greater.
We have already observed in Example I that a firm can use more debt to
increase its EPS. However, in Example II, use of higher debt is reducing the
EPS.
It is because the firm is earning an ROI of only 6.67% which lower than its
cost of debt. In example I the ROI is 13.33%, and trading on equity is
profitable.
It shows that, ROI is an important determinant of the company’s ability to
use Trading on equity and thus the capital structure.
6. Tax Rate: Since interest is a deductible expense, cost of debt is

affected by the tax rate. The firms in our examples are borrowing @
10%. Since the tax rate is 30%, the after tax cost of debt is only 7%. A
higher tax rate, thus, makes debt relatively cheaper and increases its
attraction vis-à-vis equity.
7. Floatation Costs: Process of raising resources also involves some cost.
Public issue of shares and debentures requires considerable
expenditure. Getting a loan from a financial institution may not cost
so much. These considerations may also affect the choice between
debt and equity and hence the capital structure.
8. Cost of Equity: Stock owners expect a rate of return from the equity which
is commensurate with the risk they are assuming.
When a company increases debt, the financial risk faced by the equity holders,
increases.
Consequently, their desired rate of return may increase. It is for this reason that
a company can not use debt beyond a point.
If debt is used beyond that point, cost of equity may go up sharply and share
price may decrease in spite of increased EPS.
Consequently, for maximization of shareholders’ wealth, debt can be used only
up to a level.
9. Risk Consideration: As discussed earlier, use of debt increases the

financial risk of a business.
 Financial risk refers to a position when a company is unable to meet its fixed
financial charges namely interest payment, preference dividend and
repayment obligations.
 Apart from the financial risk, every business has some operating risk (also
called business risk). Business risk depends upon fixed operating costs.
 Higher fixed operating costs result in higher business risk and vice-versa. The
total risk depends upon both the business risk and the financial risk.
 If a firm’s business risk is lower, its capacity to use debt is higher and vice-
versa.
10. Flexibility: If a firm uses its debt potential to the full, it loses
flexibility to issue further debt. To maintain flexibility, it must
maintain some borrowing power to take care of unforeseen
circumstances.
11. Control: Debt normally does not cause a dilution of control. A
public issue of equity may reduce the managements holding in the
company and make it vulnerable to takeover. This factor also
influences the choice between debt and equity especially in
companies in which the current holding of management is on a
lower side.
12. Regulatory Framework: Every company operates within a regulatory

framework provided by the law e.g., public issue of shares and debentures have
to be made under SEBI guidelines. Raising funds from banks and other financial
institutions require fulfillment of other norms. The relative ease with which
these norms can, be met or the procedures completed may also have a bearing
upon the choice of the source of finance.
13. Stock Market Conditions: If the stock markets are bullish, equity shares are
more easily sold even at a higher price. Use of equity is often preferred by
companies in such a situation. However, during a bearish phase, a company, may
find raising of equity capital more difficult and it may opt for debt. Thus, stock
market conditions often affect the choice between the two.
14. Capital Structure of other Companies: A useful guideline in the
capital structure planning is the debt equity ratios of other companies
in the same industry.
There are usually some industry norms which may help. Care
however must be taken that the company does not follow the
industry norms blindly.
For example, if the business risk of a firm is higher, it can not afford
the same financial risk. It should go in for low debt.
Thus, the management must know what the industry norms are,
whether they are following them or deviating from them and
adequate justification must be there in both cases.
 COST OF CAPITAL
• Cost of capital is an important business term for both investors and companies.
Cost of capital can best be described as the ability to cover both asset and
liability expenditures while generating a profit.
• In a nutshell, it’s a rate of return that can help companies decide to move
forward on a project or help an investor determine the risk of investing in a
company.
 Capitalstructure determine the risk assumed
by the firm
 Capital structure determine the cost of capital

of the firm
 It affect the flexibility and liquidity of the firm
 It affect the control of the owner of the firm

The Gamut of Financial
Management

Capital Structure Theories 5 Viva

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^Capital Structure

Interest 10% NIL 1,00,000 (Interest) 2,00,000 (Interest)

Corporate Tax 30% 1,20,000 90,000 60,000

EAT (Earnings after taxes) 2,80,000 2,10,000 1,40,000

• With higher use of debt, this difference

• Trading on Equity refers to the increase in profit earned by the

EBIT (PROFIT) 2,00,000 2,00,000 2,00,000

Interest-10% NIL 1,00,000 2,00,000

TAX- 30% 60,000 30,000 NIL

Deciding about the capital structure of a firm involves determining

1.Cash Flow Position: Size of projected cash flows must be

This may be calculated as follows: ICR = EBIT/ Interest.

3. Debt Service Coverage Ratio (DSCR): Debt Service Coverage

6. Tax Rate: Since interest is a deductible expense, cost of debt is

9. Risk Consideration: As discussed earlier, use of debt increases the

12. Regulatory Framework: Every company operates within a regulatory

 Capital structure determine the cost of capital

 It affect the flexibility and liquidity of the firm

 It affect the control of the owner of the firm

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