Capital Structure

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... [continues]

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