Planning and Designing Capital Structure
The choice of the combination of different sources of finance is known as the capital structure mix. Capital structure deals with the judicious use of debt and equity capital in appropriate proportions for the purpose of financing the firm’s assets. Firms should develop an optimal capital structure aiming to minimise their overall cost of capital and optimising the maximum value of the firm. Such decisions of capital structure enhance the firm’s competency and its ability to deal with the external competitive environment.
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The amount of debt financing called financial leverage is decided by the level of debt in a firm’s capital structure. The degree of financial leverage, in turn, impacts the expected risk and return faced by stockowners and creditors of any business organisation. The planning of capital structure decisions in an optimal manner is imperative for any business organisation as they tend to cater to the needs of several investors by lowering the cost of capital and maximising the value of the firm.
Figure shows the importance of a well-planned capital structure:
Let us discuss these in detail.
Risk can be minimised to a large extent when capital is structured before getting the actual money from money supplier. For example, if we structure the capital in a way where there are three sources of funding, one is by issuing equity shares, second is debentures and third is preference shares.
As debts have to be paid in time along with its interest that is fixed, any company would like to keep the debts at minimum. New businesses in particular will have lower rate of return than the interest rate. But once the business becomes well established then the company can take more debts as the Rate of interest (ROI) would be high.
Adjusting the Capital Structure
Different sources of capital can be adjusted according to the business environment. Planning of capital structure will create more sources of capital. This planning is called manoeuvrability, which means creating maximum alternatives of funding. In case banks increase their rate of interest on loans, corporates may not take loans as it would be expensive and they can opt for cheaper sources of fund.
Attributes of a Well-planned Capital Structure
The concept of optimal capital structure is concerned with the issue of choosing the right mix of debt finance and equity finance in the longterm capital structure of a firm. When a firm takes on debt finance, the value of the firm rises up to a certain point. However, beyond that point, the value of the firm shall start to decline when the debt continues to increase.
Similarly, when the firm is not able to repay the debt within the specified time period, then it shall hamper the firm’s goodwill in the market and can cause problems for obtaining further debt. Therefore, the firm must strive to select an appropriate capital structure mix with due consideration to all the factors affecting its capital structure.
There are certain characteristics of a good capital structure which are as follows:
- Profitability: Any corporate concern’s ultimate goal is to make money. Several types of capital (controlled and borrowed) should be deployed in such a way that the maximum profit margin can be given to shareholders, as well as creditors.
- Flexibility: Another feature of an ideal capital structure is its adaptability. The capital structure should be adequately responsive to variations in the capital market. In a good capital structure, increasing or decreasing capital should not be problematic.
- Conservatism: Conservatism must not be valued at the expense of adaptability. The current ratio, also known as the solvency ratio, should be kept in a good shape.
- Capacity to repay debts: The ability to repay debts demonstrates the health of a company’s capital structure. The solvency of a firm is indicated through its creditworthiness. Thus, a firm should always be careful about raising debts which involve extra cost and risks.
- Control: Another important aspect in designing optimum capital structure is to ensure control. The supplies of debt have no role to play in managing the firm; but equity holders have right to select management of the firm. So, more debt means less amount of control by the supplier of funds. Hence, the management will decide the extent of control to be retained by themselves while designing optimum capital structure.
Designing Capital Structure
The principle of optimal capital structure can be simply described in the theory, developing it in practice is complex due to a variety of elements that affect the capital structure. Furthermore, the qualitative evaluation of the firm’s financial advisor plays a role in determining the best capital structure for the company. A firm has the choice to obtain money for financing its several investment proposals from varied sources in varied proportions.
The firm can choose among a variety of patterns which may be as follows:
- Use of debt capital exclusively in case of an existing company
- Use of preference share capital exclusively in case of an existing company
- Combined use of both debt capital and equity share capital in different proportions
- Combined use of debt capital, equity share capital and preference share capital in different proportions
- Combined use of debt capital and preference share capital in different proportions in the case of an existing company
- Combined use of equity share capital and preference share capital in different proportions
Approaches to Capital Structure Designing
The following variables should be carefully examined while creating an optimum capital structure:
- Profitability: An ideal capital structure must generate enough profit. As a result, the revenue growth element must be confirmed. Also, an EBIT-EPS analysis can be conducted to determine the EPS under various financial scenarios at various levels of EBIT. Aside from EBIT-EPS evaluation, a corporation can assess the coverage ratio to determine its interest-paying potential.
- Industry average: In terms of leverage measures, the company should be compared to others in the sector. When developing the capital structure, the level of financial risk faced by other companies must be considered. In this regard, the industry average serves as a standard.
However, it is not important for the company to follow the industry average and maintain its leverage ratio at the same level as other businesses; however, the comparison will aid the company in acting as a safety valve.
- Nature of industry: When determining the best capital structure, the leadership must evaluate the type of sector in which the company operates. If the company operates in an industry with periodic revenue fluctuations, the leverage ratio must be restrained.
- Mobility in funds: There should be wide flexibility in sourcing the funds so that firm can adjust its long-term sources of funds if necessary. This will help firm to combat any unforeseen situations that may arise in the economic environment. Moreover, flexibility allows firms to avail the best opportunity that may arise in future. Management must keep provision not only for obtaining funds but also for refunding them.
- Timing of raising funds: Another key element to keep in mind when soliciting cash is the timing. At the right time, the company may be able to obtain financing at a reasonable cost. The share market, the government’s economic and financial regulations, stock prices and other economic determinants must all be monitored constantly by businesses.
- Firm’s characteristics: When establishing a capital structure, the size of the business and its credibility are crucial aspects to take into account. Because a small company’s credibility is restricted, managers cannot rely heavily on credit; instead, they must rely on equity. The advantage of capital gearing, on the other hand, may be available to a huge firm. Small businesses have restricted access to a variety of funding options.
EBIT-EPS (Approach) Analysis
The EBIT-EPS analysis is an important technique, which is used for designing the optimal capital structure of a firm. It helps in figuring out an appropriate mix of capital structure that can offer the highest earnings per share (EPS) over the firm’s expected level of EBIT. The EBIT level generally varies from one year to another and is representative of the success of a firm’s operations. EPS is a measure of a firm’s overall performance for the shareholders.
Furthermore, through an indifference approach, the EBIT-EPS analysis aims to locate that the level of EBIT which shall equate the EPS regardless of the financing plan chosen by the firm. The degree of debt financing impacts the distribution of profits among different kinds of investors of funds and raises the variability of the firm’s EPS. Thus, the financial manager should evaluate the effects of alternative financial leverages on the firm’s EPS so as to look for an optimal capital structure.
At a particular level of EBIT, EPS shall be different under varying financing mix options based upon the extent or degree of financial leverage. The degree of the financial leverage has effects on the firm’s EPS owing to the existence of fixed financial charges such as interest on debt and financial fixed dividend on preference share capital. The financial break-even point arises at that minimum level of EBIT, which is required to fulfil all the fixed financial expenditures.
It indicates the level of EBIT for which the firm’s EPS equals zero. When the EBIT is lower than the break-even point, the firm’s EPS shall be negative. However, when the EBIT is more than the financial breakeven point, then more fixed costs instruments can be acquired into the firm’s capital structure.
The EBIT-EPS break-even analysis is useful for the determination of the appropriate quantum of debt a firm might carry. Moreover, the EPS equivalency point or indifference point can be computed, which shows that between two given financing options (irrespective of the level of leverage in the financial alternatives), EPS shall be the same at a particular level of EBIT.
An EBIT-EPS indifference analysis chart is shown in Figure which helps in examining the EPS results for alternative financial plans at varying EBIT levels.
The EBIT-EPS analysis is a widely used technique to determine the level of debt in a business firm. Through such analysis, a comparison can be made for various methods of financing by obtaining an indifference point. This is a point to the EBIT level at which the EPS remains unchanged irrespective of the level of firm’s debt-equity mix.
The EPS equivalency point or indifference point can be calculated in the following manner:
EBIT = Indifference point
E1 = Number of equity shares in Alternative 1
E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
I2 = Interest charges in Alternative 2
T = Tax-rate
Let us understand the EBIT-EPS analysis with the help of a few illustrations:
Illustration 1: MPS Limited requires a capital of ₹12,50,000 for a new plant. Such plant is expected to generate an EBIT of ₹2,50,000. The company is open to 3 financing alternatives for obtaining funds to acquire the plant, i.e., by raising debt capital of ₹1,25,000 or ₹5,00,000 or ₹7,50,000 and the balance, in each case, through the issue of equity shares.
The market price of the company’s share is presently selling at ₹75, which is expected to decrease to ₹62.50 in case where the borrowed funds exceed ₹5,00,000. Moreover, the money can be borrowed at the interest rate of 10 per cent up to ₹1,25,000, at 15 per cent over ₹1,25,000 and up to ₹5,00,000 and at ₹20 per cent over ₹5,00,000. The corporate tax rate is 50 per cent.
While deciding about the financing alternative, the company follows the objective of maximising its EPS. Which financial alternative should the company consider?
Plan I: Raising debt of ₹1,25,000 + Equity shares of ₹11,25,000
Plan II: Raising debt of ₹5,00,000 + Equity shares of ₹7,50,000
Plan III: Raising debt of ₹7,50,000 + Equity shares of ₹5,00,000
Calculation of Earnings per share (EPS):
|Particulars||Financial Plan I (₹)||Financial Plan II (₹)||Financial Plan III (₹)|
|Less: Interest (Note 1)||12,500|
|Earnings before taxes||23,75,00||1,81,250||1,31,250|
|Less: Taxes @ 50%||1,18,750||90,625||65,625|
|Earnings after taxes (EAT)||1,18,750||90,625||65,625|
|Number of shares (Note 2)||15,000||10,000||8,000|
|Earnings per share (EPS)||7.9166||9.0625||8.2031|
Thus, the financing plan II (raising debt of ₹5,00,000 and issue of equity share capital of ₹7,50,000) is the option which maximises the earnings per share of the company. Hence, this plan must be chosen by the company.
Note 1: Computation of interest on debt
|Plan I||1,25,000 × 10%||= ₹12,500|
|Plan II||1,25,000 × 10%|
|3,75,000 × 15%||= ₹68,750|
|Plan III||1,25,000 × 10%|
|3,75,000 × 15%|
|2,50,000 × 20%||= ₹1,18,750|
Note 2: Computation of number of equity shares to be issued
|Plan I||= ₹11,25,000 ÷ 75||15,000 shares|
|Plan II||= ₹7,50,000 ÷ 75||10,000 shares|
|Plan III||= ₹5,00,000÷ 62.50||8,000 shares|
Illustration 2: Smriti Limited is considering three financing plans, Plan A, B and C. The key information relating to such plans is as follows:
(a) Total amount of investment to be raised is ₹4,00,000.
(b) Plans of financing proportion:
|Plans||Equity share capital||Debt capital||Preference share capital|
(c)Cost of debt and cost of preference shares is 8% each.
(d) The corporate tax rate is 50%.
(e) The equity shares are of the face value of ₹20 each and will be issued at a premium of ₹20 per share.
(f) The expected EBIT of the company is ₹1,60,000.
The finance manager of the company is contemplating the EBIT-EPS approach for choosing between the three financing plans available. For this purpose, he wishes to compute the EPS under each plan, the financial break-even point of each plan and the indifference points between alternative methods of financing. Determine EPS for each financing plan. Also, determine the financial break-even point for each financing plan. Compute the EBIT range among the plans for indifference. Also, indicate if any of the plans dominate.
Solution: Computation of Earnings Per Share (EPS)
|Particulars||Financial Plan A (₹)||Financial Plan B (₹)||Financial Plan C (₹)|
|Less: Interest charges||–||(2,00,000 × 8%) = 16,000||–|
|Earnings before taxes (EBT)||1,60,000||1,44,000||1,60,000|
|Less: Taxes @ 50%||80,000||72,000||80,000|
|Earnings after taxes (EAT)||80,000||72,000||80,000|
|Less: Preference Dividend||–||–||(2,00,000 × 8%) = 16,000|
|Earnings available for equity shareholders||80,000||72,000||64,000|
|Number of equity shares||= 4,00,000 ÷ 40 = 10,000||= 2,00,000 ÷ 40 = 5,000||= 2,00,000 ÷ 40 = 5,000|
|Earnings per share (EPS)||8||14.40||12.80|
Financial Plan B maximises the EPS of the company. The financial break-even point is the EBIT level equal to the fixed finance charges and preference dividend.
For Plan A: The financial break-even point is zero since there is no interest or preference dividend payment.
For Plan B: The financial break-even point is ₹16,000 since there is an interest charge with no preference dividend payment.
For Plan C: The financial break-even point is before tax earnings of ₹32,000 (i.e., 16,000 ÷ 0.50) since there is an after-tax preference dividend payment with no interest charge.
Indifference point that is level of EBIT where EPS of Plan A and Plan B is equal to zero
This implies that if expected level of EBIT is 32,000 then firm is indifferent between financing plan A & B. If expected EBIT is below 32,000 then plan A should be chosen and for expected EBIT level of above 32,000, plan B will result into higher EPS.
Indifference point that is level of EBIT where EPS of Plan A and Plan C is equal to zero
Indifference point where EBIT of Plan B and Plan C is equal
There is no indifference point between Plan B and C. Therefore, Plan B dominates Plan C. This is so because the financial break-even point of Plan B is only ₹16,000, while that for Plan C is ₹64,000.
Cash flow analysis proves to be a supporting parameter for the EBITEPS analysis in deciding a suitable capital structure. The cash flow approach states that cash flow situations of a firm under adverse conditions must be examined with a view to determine its debt capacity. If the company has the capability to generate ample cash flows, then a high debt-equity ratio does not signify risk for a firm. Therefore, until the point cash flows are equal to the risk set out by debt capital, it is possible for the firm to increase its debt.
One of the main disadvantages of this approach is that it does not take into account uncertainty factors due to changes in political climate or technological developments. However, with information on cash flow analysis, this approach aims to provide a solution to the problem of determining a debt range for identifying an optimum level of debt in the firm’s capitals structure. The study of cash flow is critical to fulfil a firm’s fixed service fee.
It shows the company’s ability to satisfy certain obligations, such as fixed surcharges, which comprise fixed operational costs and interest on debt capital. Thus, in addition to EBIT-EPS analysis in capital structure planning, a study of the firm’s profitability to service fixed costs is without a doubt an important instrument for evaluating a financial risk. We know that as the amount of loan capital increases, so does the level of uncertainty that a company must deal with to pay its fixed charge obligations.
Because if a company borrows more than it can afford and then fails to make its maturing obligations at a later period, collectors will seize the company’s assets to satisfy their unpaid claims, resulting in financial insolvency. As fixed interest costs are paid in cash, an examination of predicted future cash flows must be carefully evaluated before accepting any further borrowed capital.
As a result, cash flow analysis provides crucial information in this area. If a company’s predicted future cash flow is higher and more stable, it should consider taking on more debt as a source of funding. Similarly, if future cash flows are likely to be unstable and lower, a company should avoid fixed charge instruments, which are considered a high-risk investment. Furthermore, cash flow analysis provides the following key benefits that aid in the preparation of the debt-equity mix in a company’s entire capital structure.
- A cash flow analysis reveals a company’s liquidity position when it is in a bad situation.
- It keeps track of the different modifications introduced to the balance sheet as well as other cash flows that aren’t shown in the Profit and Loss Account.
- It examines the financial difficulties in a dynamic framework across time.