Capital Structure

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Capital Structure Decision
A Summary
Prepared By:Harsh Mehta: 40344 Hiral Dodia: 60226 Mihir Gada: 61183 Pratik Ganatra: 64510 Sweta Shah: 60641 Course: Financial Management 2 Instructor: Prof. J Mamtora

Chapter 20: Capital Structure Decision
Introduction This chapter discusses different kinds of analyses helpful in choosing the capital structure, explores certain guidelines relevant for capital structure decision, and examines capital structure policies in practices. A variety of analyses are done in practice to get handle over the capital structure decision. These are:  PBIT-EPS analysis: This looks at how alternative capital structures influence the earnings per share.  ROI-ROE analysis: This assesses the impact of alternative capital structures on return on equity.  Leverage analysis: This examines the operating, financial and total leverage and their effects.  Ratio analysis: This analysis relies on certain leverage ratios.  Cash flow analysis: This determines the level of debt that can be serviced by the expected cash flow of the firm.  Comparative analysis: This relies on what the other comparable firms are doing. Each of these analyses in incomplete and provides partial information about the best capital structure that maximizes the value of the firm.

20.1 PBIT-EPS Analysis

To identify an appropriate capital structure, we need to understand how sensitive EPS is to changes in PBIT under different financing alternatives. The basic relationship between PBIT and EPS is as follows:-

With the help of the above equation the breakeven PBIT for two alternative financing plans (viz. the level of PBIT for which the EPS is the same under both financing plans) can be obtained. This can be obtaining by solving for PBIT under the following mathematical relationship:-

(PBIT*- I1)(1-t)/n1= (PBIT* -I2) (1-t)/n2 Where PBIT* is the PBIT indifference point between the two alternative financing plans. I 1 & I2 are the interest expenses before taxes, t is the income-tax rate, and n1 & n2 are the number of equity shares outstanding under financing plans 1 & 2. Now, to determine the best capital structure, the financial manager may do two things:1. Compare the expected value of PBIT with its indifference value 2. Asses the probability of PBIT falling below its indifference value. If the most likely PBIT exceeds the indifference value of PBIT, the debt financing option may be advantageous; otherwise the equity financing option may be advantageous.

20.2 ROI-ROE Analysis

To identify an appropriate capital structure, we need to understand how sensitive ROE is to changes in ROI under different financing alternatives. The basic relationship between ROI and ROE is as follows:-

Where the ROE is the return on equity, ROI is the return on investment, r is the cost of debt, D/E is the debt-equity ratio, and t is the tax rate. This relationship can be used to obtain the relationship between the ROI and ROE. If the ROE under the two capital structures is the same the ROI is equal to the cost of debt. Hence the indifference value of ROI is equal to the cost of debt. Thus best capital structure can be thus chosen in which the ROE is higher for the following two cases:1. ROI is less than the cost of debt. 2. ROI is more than the cost of debt.

20.3 Leverage Analysis

Leverage arises from the existence of fixed costs. There are two kinds of leverage, viz. 1. Operating Leverage. 2. Financial Leverage. These can be explained by the following diagram:-

Operating Leverage: It arises from the existence of fixed operating expenses. When a firm has fixed operating expenses, 1 percent changes in unit sales lead to more than 1 percent change in EBIT. Thus the sensitivity of profit before interest and taxes to changes in unit sales is referred to as the degree of operating leverage (DOL). It can be mathematically represented by the following relationship:-





Financial Leverage: Financial leverage...
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