Financing-Decisions-Capital-Structure-Quick Revision for Exam.docx

© The Institute of Chartered Accountants of India
FINANCING DECISIONS
CAPITAL STRUCTURE
LEARNING OUTCOMES
 State the meaning and significance of capital structure.
 Discuss the various capital structure theories i.e. Net Income
Approach, Traditional Approach, Net Operating Income (NOI)
Approach, Modigliani and Miller (MM) Approach, Trade- off
Theory and Pecking Order Theory.
 Describe concepts and factors for designing an optimal
capital structure.
 Discuss essential features of capital structure of an entity.
 Discuss optimal capital structure.
 Analyse the relationship between the performance of a
company and its impact on the earnings of the shareholders
i.e. EBIT-EPS analysis.
 Discuss the meaning, causes and consequences of over and
under capitalisation to an entity.
CHAPTER 5

Capital Structure Decision
FINANCIAL MANAGEMENT
Capital Structure Theories
● Net Income (NI) Approach
● Traditional Approach
● Net Operating Income(NOI)
Approach
● Modigliani- Miller (MM)
Approach
● Trade-off Theory
● Pecking Order Theory
Designing an Optimal Capital Structure
EBIT- EPS Analysis
5.1 MEANING OF CAPITAL STRUCTURE
Capital structure is the combination of capitals from different sources of finance.
The capital of a company consists of equity share holders’ fund, preference share
capital and long term external debts. The source and quantum of capital is decided
keeping in mind following factors:
1. Control: capital structure should be designed in such a manner that existing
shareholders continue to hold majority stack.
2. Risk: capital structure should be designed in such a manner that financial risk
of the company does not increases beyond tolerable limit.
3. Cost: overall cost of capital remains minimum.
5.2

Value of the firm =
EBIT
Overall cost of capital / Weighted average cost of capital
Ko = (Cost of debt × weight of debt) + (Cost of equity × weight of equity)
Ko = [{Kd × D/ (D+S)} + {Ke × S/(D+S)}]
FINANCING DECISIONS – CAPITAL STRUCTURE
Practically it is difficult to achieve all of the above three goals together hence a
finance manager has to make a balance among these three objectives.
However, the objective of a company is to maximise the value of the company and
it is prime objective while deciding the optimal capital structure. Capital Structure
decision refers to deciding the forms of financing (which sources to be tapped);
their actual requirements (amount to be funded) and their relative proportions
(mix) in total capitalisation.
Where:
 Ko is the weighted average cost of capital (WACC)
 Kd is the cost of debt
 D is the market value of debt
 S is the market value of equity
 Ke is the cost of equity
Capital structure decision will decide weight of debt and equity and ultimately
overall cost of capital as well as Value of the firm. So capital structure is relevant in
maximizing value of the firm and minimizing overall cost of capital.
Whenever funds are to be raised to finance investments, capital structure decision
is involved. A demand for raising funds generates a new capital structure since a
decision has to be made as to the quantity and forms of financing. The process of
financing or capital structure decision is depicted in the figure below.
5.3

Financing Decision Process
5.2 CAPITAL STRUCTURE THEORIES
The following approaches explain the relationship between cost of capital, capital
structure and value of the firm:
Capital Structure
Theories
Capital Structure
Relevance Theory
Capital Structure
Irrelevance Theory
Net Income (NI)
Approach
Traditional Approach
Net Operating
Income (NOI)
Approach
Modigliani and Miller
(MM) Approach
5.4

Cost of
Capital % Ke
Kw
Kd
Leverage
(a) Net Income (NI) approach
(b) Traditional approach.
(c) Net Operating Income (NOI) approach
(d) Modigliani-Miller (MM) approach
However, the following assumptions are made to understand this relationship.
 There are only two kinds of funds used by a firm i.e. debt and equity.
 The total assets of the firm are given. The degree of average can be changed
by selling debt to purchase shares or selling shares to retire debt.
 Taxes are not considered.
 The payout ratio is 100%.
 The firm’s total financing remains constant.
 Business risk is constant over time.
 The firm has perpetual life.
5.2.1 Net Income (NI) Approach
According to this approach, capital structure decision is relevant to the value of
the firm. An increase in financial leverage will lead to decline in the weighted
average cost of capital (WACC), while the value of the firm as well as market price
of ordinary share will increase. Conversely, a decrease in the leverage will cause an
increase in the overall cost of capital and a consequent decline in the value as well
as market price of equity shares.
5.5

Value of Firm (V) = S + D
Overall cost of capital =
EBIT
Value of the firm
From the above diagram, Ke and Kd are assumed not to change with leverage. As
debt increases, it causes weighted average cost of capital (WACC) to decrease.
The value of the firm on the basis of Net Income Approach can be ascertained as
follows:
Where,
V = Value of the firm
S = Market value of equity
D = Market value of debt
Where,
NI = Earnings available for equity shareholders
Ke
= Equity Capitalisation rate
Under, NI approach, the value of the firm will be maximum at a point where
weighted average cost of capital (WACC) is minimum. Thus, the theory suggests
total or maximum possible debt financing for minimising the cost of capital. The
overall cost of capital under this approach is:
Thus according to this approach, the firm can increase its total value by decreasing
its overall cost of capital through increasing the degree of leverage. The significant
conclusion of this approach is that it pleads for the firm to employ as much debt
as possible to maximise its value.
ILLUSTRATION 1
Rupa Ltd.’s EBIT is ` 5,00,000. The company has 10%,` 20 lakh debentures. The equity
capitalization rate i.e. Ke is 16%.
You are required to CALCULATE:
(i) Market value of equity and value of firm
Market value of equity (S) =
NI
K
e
5.6

(ii) Overall cost of capital.
SOLUTION
(i) Statement showing value of firm
`
EBIT 5,00,000
Less: Interest on debentures (10% of ` 20,00,000) (2,00,000)
Earnings available for equity holders i.e. Net Income (NI) 3,00,000
Equity capitalization rate (Ke) 16%
Market value of equity (S) 
NI

 3,00,000
100


K

16.00


e   18,75,000
Market value of debt (D) 20,00,000
Total value of firm V = S + D 38,75,000
(ii) Overall cost of capital 
EBIT

`5,00,000
12.90%
Value of
5.2.2 Traditional Approach
firm `38,75,000
This approach favours that as a result of financial leverage up to some point, cost
of capital comes down and value of firm increases. However, beyond that point,
reverse trends emerge. The principle implication of this approach is that the cost
of capital is dependent on the capital structure and there is an optimal capital
structure which minimises cost of capital.
Under this approach:
1. The rate of interest on debt remains constant for a certain period and
thereafter with an increase in leverage, it increases.
2. The expected rate by equity shareholders remains constant or increase
gradually. After that, the equity shareholders starts perceiving a financial risk
and then from the optimal point and the expected rate increases speedily.
3. As a result of the activity of rate of interest and expected rate of return, the
WACC first decreases and then increases. The lowest point on the curve is
optimal capital structure.
5.7

Optimum capital structure occurs at the point where value of the firm is highest
and the cost of capital is the lowest.
According to net operating income approach, capital structure decisions are totally
irrelevant. Modigliani-Miller supports the net operating income approach but
provides behavioural justification. The traditional approach strikes a balance
between these extremes.
Main Highlight of Traditional Approach
The firm should strive to reach the optimal capital structure and its total valuation
through a judicious use of the both debt and equity in capital structure. At the
optimal capital structure, the overall cost of capital will be minimum and the value
of the firm will be maximum.
ILLUSTRATION 2
Indra Ltd. has EBIT of ` 1,00,000. The company makes use of debt and equity capital.
The firm has 10% debentures of ` 5,00,000 and the firm’s equity capitalization rate
is 15%.
You are required to COMPUTE:
(i) Current value of the firm
(ii) Overall cost of capital.
SOLUTION
(i) Calculation of total value of the firm
`
EBIT 1,00,000
5.8

Less: Interest (@10% on ` 5,00,000) 50,000
Earnings available for equity holders 50,000
Equity capitalization rate i.e. Ke 15%
Value of equity holders=
Earnings available for equity holders
Value of equity (S)
=
50,000
= ` 3,33,333
0.15
Value of Debt (given) D 5,00,000
Total value of the firm V = D + S (5,00,000 + 3,33,333) 8,33,333
(ii) Overallcost of capital  K
 S 
e

V

D 
d

V
 or
EBIT
V
   
 0.15
 3,33,333 
 0.10
5,00,000 

8,33,333
 
8,33,333


   

1
50,000  50,000= 12.00%
8,33,333
ILLUSTRATION 3
DETERMINE the optimal capital structure of a company from the following
information:
Options Cost of
Debt(Kd) in %
Cost of
Equity(Ke) in %
Percentage of Debt on total
value (Debt +Equity)
1 11 13.0 0.0
2 11 13.0 0.1
3 11.6 14.0 0.2
4 12.0 15.0 0.3
5 13.0 16.0 0.4
6 15.0 18.0 0.5
7 18.0 20.0 0.6
5.9
 K
o
 K

SOLUTION
Note that the ration given in this question is not debt to equity ratio. Rather than
it is the debt to value ratio. Therefore, if the ratio is 0.6, it means that capital
employed comprises 60% debt and 40% equity.
𝐾𝑂𝑂 =
𝐾𝑑×𝐷 + 𝐾𝑒×𝑆
𝐷 + 𝑆
In this question total of weight is equal to 1 in all cases, hence we need not to
divide by it.
1) K0 = 11% x 0 + 13% x 1 = 13%
2) K0 = 11% x 0.1 + 13% x 0.9 = 12.8%
3) K0 = 11.6% x 0.2 + 14% x 0.8 = 13.52%
4) K0 = 12% x 0.3 + 15% x 0.7 = 14.1%
5) K0 = 13% x 0.4 + 16% x 0.6 = 14.8%
6) K0 = 15% x 0.5 + 18% x 0.5 = 16.5%
7) K0 = 18% x 0.6 + 20% x 0.4 = 18.8%
Decision: 2nd
option is the best because it has lowest WACC.
5.2.3 Net Operating Income Approach (NOI)
NOI means earnings before interest and tax (EBIT). According to this approach,
capital structure decisions of the firm are irrelevant.
Any change in the leverage will not lead to any change in the total value of the firm
and the market price of shares, as the overall cost of capital is independent of the
degree of leverage. As a result, the division between debt and equity is irrelevant.
As per this approach, an increase in the use of debt which is apparently cheaper is
offset by an increase in the equity capitalisation rate. This happens because equity
investors seek higher compensation as they are opposed to greater risk due to the
existence of fixed return securities in the capital structure.
5.10

The above diagram shows that Ko (Overall capitalisation rate) and (debt –
capitalisation rate) are constant and Ke (Cost of equity) increases with leverage.
ILLUSTRATION 4
Amita Ltd’s operating income (EBIT) is ` 5,00,000. The firm’s cost of debt is 10% and
currently the firm employs ` 15,00,000 of debt. The overall cost of capital of the firm
is 15%.
You are required to CALCULATE:
(i) Total value of the firm.
(ii) Cost of equity.
SOLUTION
(i) Statement showing value of the firm
`
Net operating income/EBIT 5,00,000
Less: Interest on debentures (10% of ` 15,00,000) (1,50,000)
Earnings available for equity holders 3,50,000
Total cost of capital (K0) (given) 15%
Value of the firm V =
EBIT
=
`5,00,000
k0 0.15 33,33,333
(ii) Calculation of cost of equity
`
Market value of debt (D) 15,00,000
Market value of equity (s) S = V − D = `33,33,333 – `15,00,000 18,33,333
5.11

Ke =
Earnings available for equity holders
Value of equity(S)
Or, 
EBIT  Interest paid on debt
=
`3,50,000
=19.09%
Market value of equity `18,33,333
OR
K =K f Sı
h
+K
fDıh
o e ı d ı
yV yV
K =K f Vıh
-K
fDıh
e o ı d ı
yS yS
=0.15
f33,33,333ıh
- 0.10
f15,00,000ıh
y ı ı
18,33,333 y18,33,333
=
1
[(0.15×33,33,333)- (0.10×15,00,000)]
18,33,333
=
1
[5,00,000 -1,50,000] = 19.09%
18,33,333
ILLUSTRATION 5
Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd.
has 50 per cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt
and 80 per cent equity. (All percentages are in market-value terms). The borrowing
rate for both companies is 8 per cent in a no-tax world, and capital markets are
assumed to be perfect.
(a) (i) If you own 2 per cent of the shares of Alpha Ltd., DETERMINE your return
if the company has net operating income of `3,60,000 and the overall
capitalisation rate of the company, K0 is 18 per cent?
(ii) CALCULATE the implied required rate of return on equity?
(b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) DETERMINE the
implied required equity return of Beta Ltd.? (ii) ANALYSE why does it differ from
that of Alpha Ltd.?
SOLUTION
(a) Value of the Alpha Ltd. =
NOI
=
K0
` 3,60,000
= ` 20,00,000
18%
5.12

(i) Return on Shares on Alpha Ltd.
`
Value of the company 20,00,000
Market value of debt (50%) 10,00,000
Market value of shares (50%) 10,00,000
`
Net operating income 3,60,000
Interest on debt (8% × `10,00,000) 80,000
Earnings available to shareholders 2,80,000
Return on 2% shares (2% × ` 2,80,000) 5,600
(ii) Implied required rate of return on equity =
(b) (i) Calculation of Implied rate of return
` 2,80,000
=28%
`10,00,000
`
Total value of company 20,00,000
Market value of debt (20% × `20,00,000) 4,00,000
Market value of equity (80% × `20,00,000) 16,00,000
`
Net operating income 3,60,000
Interest on debt (8%× `4,00,000) 32,000
Earnings available to shareholders 3,28,000
Implied required rate of return on equity =
` 3,28,000
=20.5%
`16,00,000
(ii) It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its
capital structure. As the equity capitalisation is a linear function of the
debt-to-equity ratio when we use the net operating income approach,
the decline in required equity return offsets exactly the disadvantage of
not employing so much in the way of “cheaper” debt funds.
5.13

Value of a firm =
NetOperating Income(NOI)
K0
5.2.4 Modigliani-Miller Approach (MM)
The NOI approach is definitional or conceptual and lacks behavioural significance.
It does not provide operational justification for irrelevance of capital structure.
However, Modigliani-Miller approach provides behavioural justification for
constant overall cost of capital and therefore, total value of the firm.
Modigliani-Miller (MM)
Approach
MM Approach -1958: without
tax
MM Approach- 1963: with tax
MM Approach – 1958: without tax:
This approach describes, in a perfect capital market where there is no transaction
cost and no taxes, the value and cost of capital of a company remain unchanged
irrespective of change in the capital structure. The approach is based on further
additional assumptions like:
 Capital markets are perfect. All information is freely available and there are
no transaction costs.
 All investors are rational.
 Firms can be grouped into ‘Equivalent risk classes’ on the basis of their
business risk.
 Non-existence of corporate taxes.
Based on the above assumptions, Modigliani-Miller derived the following three
propositions:
(i) Total market value of a firm is equal to its expected net operating income
divided by the discount rate appropriate to its risk class decided by the
market.
Value of levered firm (Vg) = Value of unlevered firm (Vu)
5.14

(ii) A firm having debt in capital structure has higher cost of equity than an
unlevered firm. The cost of equity will include risk premium for the financial
risk. The cost of equity in a levered firm is determined as under:
Ke = Ko + (Ko – Kd)
Debt
Equity
(iii) The structure of the capital (financial leverage) does not affect the overall cost
of capital. The cost of capital is only affected by the business risk.
It is evident from the above diagram that the average cost of the capital (Ko) is a
constant and not affected by leverage.
The operational justification of Modigliani-Miller hypothesis is explained through
the functioning of the arbitrage process and substitution of corporate leverage by
personal leverage. Arbitrage refers to buying asset or security at lower price in one
market and selling it at a higher price in another market. As a result, equilibrium is
attained in different markets. This is illustrated by taking two identical firms of
which one has debt in the capital structure while the other does not. Investors of
the firm whose value is higher will sell their shares and instead buy the shares of
the firm whose value is lower. They will be able to earn the same return at lower
outlay with the same perceived risk or lower risk. They would, therefore, be better
off.
The value of the levered firm can neither be greater nor lower than that of an
unlevered firm according this approach. The two must be equal. There is neither
advantage nor disadvantage in using debt in the firm’s capital structure.
5.15
Percentage

(i) Value of a levered company = Value of an unlevered company + Tax benefit
Or, Vg = Vu + TB
(ii) Cost of equity in a levered company (Keg) = Keu + (Keu – Kd)
Debt
Debit +Equity
(iii) WACC in a levered company (Kog)= Keu(1-tL)
The approach considers capital structure of a firm as a whole pie divided into
equity, debt and other securities. No matter how the capital structure of a firm is
divided (among debt, equity etc.), there is a conservation of investment value. Since
the total investment value of a corporation depends upon its underlying
profitability and risk, it is invariant with respect to relative changes in the firm’s
financial capitalisation.
According to MM, since the sum of the parts must equal the whole, therefore,
regardless of the financing mix, the total value of the firm stays the same.
The shortcoming of this approach is that the arbitrage process as suggested by
Modigliani-Miller will fail to work because of imperfections in capital market,
existence of transaction cost and presence of corporate income taxes.
MM Approach- 1963: with tax
In 1963, MM model was amended by incorporating tax, they recognised that the
value of the firm will increase, or cost of capital will decrease where corporate taxes
exist. As a result, there will be some difference in the earnings of equity and debt-
holders in levered and unlevered firm and value of levered firm will be greater than
the value of unlevered firm by an amount equal to amount of debt multiplied by
corporate tax rate.
MM has developed the formulae for computation of cost of capital (Ko), cost of
equity (Ke) for the levered firm.
Where,
Keg = Cost of equity in a levered company
Keu = Cost of equity in an unlevered company
Kd = Cost of debt
t = Tax rate
Where,
Kog = WACC of a levered company
5.16

ILLUSTRATION 6: When value of levered firm is more than the value of
unlevered firm
Keu = Cost of equity in an unlevered company
t = Tax rate
L =
Debt
Debt+Equity
There are two company N Ltd. and M Ltd., having same earnings before interest and
taxes i.e. EBIT of ` 20,000. M Ltd. is a levered company having a debt of `1,00,000
@ 7% rate of interest. The cost of equity of N Ltd. is 10% and of M Ltd. is 11.50%.
COMPUTE how arbitrage process will be carried on?
SOLUTION
Company
M Ltd. N Ltd.
EBIT (NOI) ` 20,000 ` 20,000
Debt (D) ` 1,00,000 ---
Ke 11.50% 10%
Kd 7% ---
Value of equity (S) =
NOI Interest
Cost of equity

20,000  7,000
M 11.50%
= ` 1,13,043

20,000
N 10%
= ` 2,00,000
VM = 1,13,043 + 1,00,000 {V = S + D} = ` 2,13,043
VN=` 2,00,000
Arbitrage Process:
If you have 10% shares of M Ltd., your value of investment in equity shares is 10%
of `1,13,043 i.e. ` 11,304.30 and return will be 10% of (`20,000 – `7,000) = ` 1,300.
5.17
S
S

Alternate Strategy will be:
Sell your 10% share of levered firm for ` 11,304.30 and borrow 10% of levered firms
debt i.e. 10% of ` 1,00,000 and invest the money i.e. 10% in unlevered firms stock:
Total resources /Money we have = `11,304.30 + `10,000 = `21,304.3 and you invest
10% of `2,00,000 = ` 20,000
Surplus cash available with you is = `21,304.3 – `20,000 = ` 1,304.3
Your return = 10% EBIT of unlevered firm – Interest to be paid on borrowed funds
i.e. = 10% of ` 20,000 – 7% of ` 10,000 = `2,000 – `700 = ` 1,300
i.e. your return is same i.e. ` 1,300 which you are getting from N Ltd. before
investing in M Ltd. but still you have ` 1,304.3 excess money available with you.
Hence, you are better off by doing arbitrage.
In the above example you have not invested entire amount received from “sale of
shares of levered company plus amount borrowed”. You maintained same level of
earning and reduced investment. Alternatively, you could have invested entire
amount in unlevered company. In that case your annual earnings would have
increased. An example for the same is as follows:
ILLUSTRATION 7
Following data is available in respect of two companies having same business risk:
Capital employed = ` 2,00,000 ,EBIT = ` 30,000
Ke = 12.5%
Sources Levered Company (`) Unlevered Company(`)
Debt (@10%) 1,00,000 Nil
Equity 1,00,000 200000
Investor is holding 15% shares in levered company. CALCULATE increase in annual
earnings of investor if he switches his holding from Levered to Unlevered company.
SOLUTION
1. Valuation of firms
Particulars Levered
Firm (`)
Unlevered
Firm (`)
EBIT 30,000 30,000
5.18

ILLUSTRATION 8: When value of unlevered firm is more than the value of
levered firm
Less: interest 10,000 Nil
Earnings available to Equity Shareholder/Ke 20,000 30,000
12.5% 12.5%
Value of Equity 1,60,000 2,40,000
Debt 1,00,000 Nil
Value of Firm 2,60,000 2,40,000
Value of Levered company is more than that of unlevered company therefore
investor will sell his shares in levered company and buy shares in unlevered
company. To maintain the level of risk he will borrow proportionate amount
and invest that amount also in shares of unlevered company.
2. Investment & Borrowings
Sell shares in Levered company (1,60,000x15%) 24,000
Borrow money (1,00,000 x15%) 15,000
Buy shares in Unlevered company 39,000
3. Change in Return
Income from shares in Unlevered company
(39,000 x 12.5%) 4,875
Less: interest on loan (15,000 x 10%) 1,500
Net Income from unlevered firm 3,375
Income from Levered firm (24000 x 12.5%) 3,000
Incremental Income due to arbitrage 375
There are two companies U Ltd. and L Ltd., having same NOI of `20,000 except that
L Ltd. is a levered company having a debt of `1,00,000 @ 7% and cost of equity of U
Ltd. & L Ltd. are 10% and 18% respectively.
COMPUTE how arbitrage process will work.
5.19

SOLUTION
Company
U Ltd. L Ltd.
NOI ` 20,000 ` 20,000
Debt capital – ` 1,00,000
Kd – 7%
Ke 10% 18%
Value of equity capital (s) =
EBIT Interest 

 
 Ke 
` 2,00,000
 20,000 
 
 0.10 
` 72,222
 20,000-7,000 
 
 0.18 
Total value of the firm V = S + D ` 2,00,000 ` 1,72,222
(` 72,222 +
`1,00,000)
Assume you have 10% shares of unlevered firm i.e. investment of 10% of ` 2,00,000
= ` 20,000 and Return @ 10% on ` 20,000. Investment will be 10% of earnings
available for equity i.e. 10% × 20,000 = ` 2,000.
Alternative strategy:
Sell your shares in unlevered firm for ` 20,000 and buy 10% shares of levered firm’s
equity plus debt
i.e. 10% equity of levered firm = 7,222
10% debt of levered firm = 10,000
Total investment = 17,222
Your resources are ` 20,000
Surplus cash available = Surplus – Investment = 20,000 – 17,222 = ` 2,778
Your return on investment is:
7% on debt of ` 10,000 700
10% on equity i.e. 10% of earnings available for equity holders i.e.
(10% × 13,000)
1,300
Total return 2,000
5.20

i.e. in both the cases the return received is ` 2,000 and still you have excess cash of
` 2,778.
Hence, you are better off i.e. you will start selling unlevered company shares and
buy levered company’s shares thereby pushing down the value of shares of
unlevered firm and increasing the value of levered firm till equilibrium is reached.
In the above example we have not invested entire amount received from “sale of
shares of Unlevered company”. We have also ned same level of earning and
reduced investment. Alternatively, we could have invested entire amount in Levered
company. In that case annual earnings would have increased. An example for the
same is as follows:
ILLUSTRATION 9
Following data is available in respect of two companies having same business risk:
Capital employed = ` 2,00,000 ,EBIT = ` 30,000
Sources Levered Company (`) Unlevered Company(`)
Debt (@10%) 1,00,000 Nil
Equity 1,00,000 200000
Ke 20 % 12.5%
Investor is holding 15% shares in Unlevered company. CALCULATE increase in
annual earnings of investor if he switches his holding from Unlevered to Levered
Company.
SOLUTION
1. Valuation of firms
Particulars Levered Firm (`) Unlevered Firm(`)
EBIT 30,000 30,000
Less: interest 10,000 Nil
Earnings available to Equity
Shareholder/Ke
20,000 30,000
20% 12.5%
Value of Equity 1,00,000 2,40,000
Debt 1,00,000 Nil
Value of Firm 2,00,000 2,40,000
5.21

Value of Unlevered company is more than that of Levered company therefore
investor will sell his shares in unlevered company and buy shares in levered
company. Market value of Debt and Equity of Levered company are in the
ratio of ` 1,00,000 : `1,00,000, i.e., 1:1. To maintain the level of risk he will lend
proportionate amount (50%) and invest balance amount (50%) in shares of
Levered company.
2. Investment & Borrowings `
Sell shares in Unlevered company (240000x15%) 36,000
Lend money (36000 x50%) 18,000
Buy shares in Levered company (36000 x50%) 18,000
Total 36,000
3. Change in Return
Income from shares in Levered company `
(18000 x 20%) 3,600
Interest on money lent (18000 x 10%) 1,800
Total Income after switch over 5,400
Income from Unlevered firm (36000 x 12.5%) 4,500
Incremental Income due to arbitrage 900
5.2.5 The Trade-off Theory
The trade-off theory of capital structure refers to the idea that a company chooses
how much debt finance and how much equity finance to use by balancing the costs
and benefits. Trade-off theory of capital structure basically entails offsetting the
costs of debt against the benefits of debt.
Trade-off theory of capital structure primarily deals with the two concepts - cost of
financial distress and agency costs. An important purpose of the trade-off theory
of capital structure is to explain the fact that corporations usually are financed
partly with debt and partly with equity.
It states that there is an advantage to financing with debt, the tax benefits of debt
and there is a cost of financing with debt, the costs of financial distress including
bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers
demanding disadvantageous payment terms, bondholder/ stockholder infighting,
etc).
5.22

The marginal benefit of further increases in debt declines as debt increases, while
the marginal cost increases, so that a firm that is optimizing its overall value will
focus on this trade-off when choosing how much debt and equity to use for
financing. Modigliani and Miller in 1963 introduced the tax benefit of debt. Later
work led to an optimal capital structure which is given by the trade-off theory.
According to Modigliani and Miller, the attractiveness of debt decreases with the
personal tax on the interest income. A firm experiences financial distress when the
firm is unable to cope with the debt holders' obligations. If the firm continues to
fail in making payments to the debt holders, the firm can even be insolvent.
The first element of Trade-off theory of capital structure, considered as the cost of
debt is usually the financial distress costs or bankruptcy costs of debt. The direct
cost of financial distress refers to the cost of insolvency of a company. Once the
proceedings of insolvency start, the assets of the firm may be needed to be sold at
distress price, which is generally much lower than the current values of the assets.
A huge amount of administrative and legal costs is also associated with the
insolvency. Even if the company is not insolvent, the financial distress of the
company may include a number of indirect costs like - cost of employees, cost of
customers, cost of suppliers, cost of investors, cost of managers and cost of
shareholders.
The firms may often experience a dispute of interests among the management of
the firm, debt holders and shareholders. These disputes generally give birth to
agency problems that in turn give rise to the agency costs. The agency costs may
affect the capital structure of a firm. There may be two types of conflicts -
shareholders-managers conflict and shareholders-debt holders conflict. The
introduction of a dynamic Trade-off theory of capital structure makes the
predictions of this theory a lot more accurate and reflective of that in practice.
5.23

Pecking Order Theory
Internal Financing
Debt
Equity
Trade-off Theory
Debt
Equity
As the Debt-equity ratio (i.e. leverage) increases, there is a trade-off between the
interest tax shield and bankruptcy, causing an optimum capital structure, D/E*
5.2.6 Pecking order theory
This theory is based on Asymmetric information, which refers to a situation in which
different parties have different information. In a firm, managers will have better
information than investors. This theory states that firms prefer to issue debt when
they are positive about future earnings. Equity is issued when they are doubtful and
internal finance is insufficient.
The pecking order theory argues that the capital structure decision is affected by
manager’s choice of a source of capital that gives higher priority to sources that
reveal the least amount of information.
Myres has given the name ‘PECKING ORDER’ theory as here is no well-defined debt-
equity target and there are two kind of equity internal and external. Now Debt is
cheaper than both internal and external equity because of interest. Further internal
equity is less than external equity particularly because of no transaction/issue cost,
no tax etc.
Pecking order theory suggests that managers may use various sources for raising
of fund in the following order.
1. Managers first choice is to use internal finance
2. In absence of internal finance they can use secured debt, unsecured debt,
hybrid debt etc.
3. Managers may issue new equity shares as a last option.
Financial Hierarchy
5.24

5.3 FACTORS DETERMINING CAPITAL
STRUCTURE
5.3.1 Choice of source of funds
A firm has the choice to raise funds for financing its investment proposals from
different sources in different proportions. It can:
(a) Exclusively use debt (in case of existing company), or
(b) Exclusively use equity capital, or
(c) Exclusively use preference share capital (in case of existing company), or
(d) Use a combination of debt and equity in different proportions, or
(e) Use a combination of debt, equity and preference capital in different
proportions, or
(f) Use a combination of debt and preference capital in different proportion (in
case of existing company).
The choice of the combination of these sources is called capital structure mix. But
the question is which of the pattern should the firm choose?
5.3.2 Factors affecting capital structure
While choosing a suitable financing pattern, certain fundamental principles should
be kept in minds, to design capital structure, which are discussed below:
(1) Financial leverage of Trading on Equity: The use of long-term fixed interest
bearing debt and preference share capital along with equity share capital is
called financial leverage or trading on equity. The use of long-term debt
increases the earnings per share if the firm yields a return higher than the
cost of debt. The earnings per share also increase with the use of preference
share capital but due to the fact that interest is allowed to be deducted while
computing tax, the leverage impact of debt is much more. However, leverage
can operate adversely also if the rate of interest on long-term loan is more
than the expected rate of earnings of the firm. Therefore, it needs caution to
plan the capital structure of a firm.
(2) Growth and stability of sales: The capital structure of a firm is highly
influenced by the growth and stability of its sale. If the sales of a firm are
expected to remain fairly stable, it can raise a higher level of debt. Stability of
sales ensures that the firm will not face any difficulty in meeting its fixed
5.25

commitments of interest repayments of debt. Similarly, the rate of the growth
in sales also affects the capital structure decision. Usually, greater the rate of
growth of sales, greater can be the use of debt in the financing of firm. On
the other hand, if the sales of a firm are highly fluctuating or declining, it
should not employ, as far as possible, debt financing in its capital structure.
(3) Cost Principle: According to this principle, an ideal pattern or capital
structure is one that minimises cost of capital structure and maximises
earnings per share (EPS). For e.g. Debt capital is cheaper than equity capital
from the point of its cost and interest being deductible for income tax
purpose, whereas no such deduction is allowed for dividends.
(4) Risk Principle: According to this principle, reliance is placed more on
common equity for financing capital requirements than excessive use of debt.
Use of more and more debt means higher commitment in form of interest
payout. This would lead to erosion of shareholders’ value in unfavorable
business situation. With increase in amount of Debt, financial risk increase
and vice versa.
(5) Control Principle: While designing a capital structure, the finance manager
may also keep in mind that existing management control and ownership
remains undisturbed. Issue of new equity will dilute existing control pattern
and also it involves higher cost. Issue of more debt causes no dilution in
control, but causes a higher degree of financial risk.
(6) Flexibility Principle: By flexibility it means that the management chooses
such a combination of sources of financing which it finds easier to adjust
according to changes in need of funds in future too. While debt could be
interchanged (If the company is loaded with a debt of 18% and funds are
available at 15%, it can return old debt with new debt, at a lesser interest
rate), but the same option may not be available in case of equity investment.
(7) Other Considerations: Besides above principles, other factors such as nature
of industry, timing of issue and competition in the industry should also be
considered. Industries facing severe competition also resort to more equity
than debt.
Thus, a finance manager in designing a suitable pattern of capital structure must
bring about satisfactory compromise between the above principles. The
compromise can be reached by assigning weights to these principles in terms of
various characteristics of the company.
5.26

5.4 OPTIMAL CAPITAL STRUCTURE
Objective of financial management is to maximize wealth. Therefore one should
chose a capital structure which maximizes wealth. For this purpose following
analysis should be done:
1) EBIT-EPS-MPS Analysis: chose a capital structure which maximizes market
price per share. For that start with same EBIT for all capital structures and
calculate EPS. Thereafter either multiply EPS by price earning ration or
divide it by cost of equity to arrive at MPS.
2) Indifference Point Analysis: In above analysis we have considered value at
a given EBIT only. What will happen if EBIT changes? Will it change your
decision also? To answer this question you can do indifference point
analysis.
3) Financial Break Even point Analysis: With change in capital structure,
financial risk also changes. Though this risk has already been considered
in PE ratio or in cost of equity in point one above, but one may calculate
and consider it separately also by calculating financial BEP.
5.5 EBIT-EPS-MPS ANALYSIS
5.5.1 Relationship between EBIT - EPS-MPS
The basic objective of financial management is to design an appropriate capital
structure which can provide the highest wealth, i.e., highest MPS, which in turn
depends on EPS.
Given a level of EBIT, EPS will be different under different financing mix depending
upon the extent of debt financing. The effect of leverage on the EPS emerges
because of the existence of fixed financial charge i.e., interest on debt financial
fixed dividend on preference share capital. The effect of fixed financial charge on
the EPS depends upon the relationship between the rate of return on assets and
the rate of fixed charge. If the rate of return on assets is higher than the cost of
financing, then the increasing use of fixed charge financing (i.e., debt and
preference share capital) will result in increase in the EPS. This situation is also
known as favourable financial leverage or Trading on Equity. On the other hand, if
the rate of return on assets is less than the cost of financing, then the effect may
be negative and, therefore, the increasing use of debt and preference share capital
may reduce the EPS of the firm.
5.27

The fixed financial charge financing may further be analyzed with reference to the
choice between the debt financing and the issue of preference shares. Theoretically,
the choice is tilted in favour of debt financing for two reasons: (i) the explicit cost of
debt financing i.e., the rate of interest payable on debt instruments or loans is generally
lower than the rate of fixed dividend payable on preference shares, and (ii) interest on
debt financing is tax-deductible and therefore the real cost (after-tax) is lower than the
cost of preference share capital.
Thus, the analysis of the different types of capital structure and the effect of leverage
on the expected EPS and eventually MPS will provide a useful guide to selection of a
particular level of debt financing. The EBIT-EPS analysis is of significant importance and
if undertaken properly, can be an effective tool in the hands of a financial manager to
get an insight into the planning and designing of the capital structure of the firm.
ILLUSTRATION 10
Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary
shares of ` 10 per share. The firm wants to raise ` 250,000 to finance its investments
and is considering three alternative methods of financing – (i) to issue 25,000
ordinary shares at ` 10 each, (ii) to borrow` 2,50,000 at 8 per cent rate of interest,
(iii) to issue 2,500 preference shares of ` 100 each at an 8 per cent rate of dividend.
If the firm’s earnings before interest and taxes after additional investment are
` 3,12,500 and the tax rate is 50 per cent, FIND the effect on the earnings per share
under the three financing alternatives.
SOLUTION
EPS under alternative financing favourable EBIT:
Particulars Equity
Financing (`)
Debt
Financing(`)
Preference
Financing
(`)
EBIT 3,12,500 3,12,500 3,12,500
Less: Interest 0 20,000 0
PBT 3,12,500 2,92,500 3,12,500
Less: Taxes 1,56,250 1,46,250 1,56,250
PAT 1,56,250 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
5.28

Earning available to ordinary
shareholders
1,56,250 1,46,250 136,250
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 1.25 1.46 1.36
The firm is able to maximize the earnings per share when it uses debt financing.
Though the rate of preference dividend is equal to the rate of interest, EPS is high
in case of debt financing because interest charges are tax deductible while
preference dividends are not. With increasing levels of EBIT, EPS will increase at a
faster rate with a high degree of leverage.
We know that market price per share is equal to earning per share multiplied by
price earning (PE) ratio. If PE ration is same for all three plans then the plan which
has highest EPS will also have highest MPS and it will be selected. On the other
hand if PE ratio for equity plan is 10 times, for debt plan it is 8 times and for
preference plan it is 7 times then:
EPS 1.25 1.46 1.36
PE ratio x10 x8 x7
MPS 12.50 11.68 9.52
Now despite lower EPS, equity plan will be selected because it has highest MPS.
However, if a company is not able to earn a rate of return on its assets higher than the
interest rate (or the preference dividend rate), debt (or preference financing) will have
an adverse impact on EPS. Suppose the firm in illustration above has an EBIT of
`75,000/-, then EPS under different methods will be as follows:
EPS under alternative financing methods: Unfavourable EBIT:
Particulars Equity
Financing (`)
Debt
Financing(`)
Preference
Financing (`)
EBIT 75,000 75,000 75,000
Less: Interest 0 20,000 0
PBT 75,000 55,000 75,000
Less: Taxes 37,500 27,500 37,500
PAT 37,500 27,500 37,500
Less: Preference dividend 0 0 20,000
5.29

Earning available to ordinary
shareholders
37,500 27,500 17,500
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 0.30 0.275 0.175
It is obvious that under unfavourable conditions, i.e. when the rate of return on the
total assets is less than the cost of debt, the earnings per share will fall with the
degree of leverage.
5.5.2 Financial Break-even and Indifference Analysis
Financial break-even point is the minimum level of EBIT needed to satisfy all the
fixed financial charges i.e. interest and preference dividends. It denotes the level of
EBIT for which the company’s EPS equals zero.
If the EBIT is less than the financial breakeven point, then the EPS will be negative
but if the expected level of EBIT is more than the breakeven point, then more fixed
costs financing instruments can be taken in the capital structure, otherwise, equity
would be preferred.
EBIT-EPS breakeven analysis is used for determining the appropriate amount of
debt a company might carry.
Another method of considering the impact of various financing alternatives on
earnings per share is to prepare the EBIT chart or the range of Earnings Chart. This
chart shows the likely EPS at various probable EBIT levels. Thus, under one particular
5.30

alternative, EPS may be ` 2 at a given EBIT level. However, the EPS may go down if
another alternative of financing is chosen even though the EBIT remains at the same
level. At a given EBIT, earnings per share under various alternatives of financing
may be plotted. A straight line representing the EPS at various levels of EBIT under
the alternative may be drawn. Wherever this line intersects, it is known as break-
even point. This point is a useful guide in formulating the capital structure. This is
known as EPS equivalency point or indifference point since this shows that, between
the two given alternatives of financing (i.e., regardless of leverage in the financial
plans), EPS would be the same at the given level of EBIT.
The equivalency or indifference point can also be calculated algebraically in the
following manner:
Where,
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
Just keep in mind that if amount of equity share capital is same under two financial
plans then one of the following two situations will arise:
1. No indifference point: if after tax cost of the source other than equity shares
is not same under both plans then there will be no indifference point
between the two. Because one plan will be better than other at all levels of
EBIT. For example if two plans have equity shares of ` 1,00,000 each. Plan 1
has 10% debentures of ` 50,000 while plan 2 has 8% Term loan of ` 50,000.
Then plan 2 will be better than plan 1 at any level of EBIT and there will be no
indifference point
5.31
(EBIT-I1)(1-t)
=
(EBIT-I2)(1-t)
E1 E2

EPS Plan 2
Plan 1
EBIT
EPS Plan 1
Plan 2
Both lines will
coincide
EBIT
2. Many indifference points: if after tax cost of the source other than equity
shares is same under both plans then each EBIT will be an indifference point.
Debt-Equity Indifference Point
ILLUSTRATION 11
Best of Luck Ltd., a profit making company, has a paid-up capital of ` 100 lakhs
consisting of 10 lakhs ordinary shares of ` 10 each. Currently, it is earning an annual
pre-tax profit of ` 60 lakhs. The company's shares are listed and are quoted in the
range of ` 50 to ` 80. The management wants to diversify production and has
approved a project which will cost ` 50 lakhs and which is expected to yield a pre-tax
income of ` 40 lakhs per annum. To raise this additional capital, the following options
are under consideration of the management:
5.32

(a) To issue equity share capital for the entire additional amount. It is expected
that the new shares (face value of ` 10) can be sold at a premium of ` 15.
(b) To issue 16% non-convertible debentures of ` 100 each for the entire amount.
(c) To issue equity capital for ` 25 lakhs (face value of ` 10) and 16% non-
convertible debentures for the balance amount. In this case, the company can
issue shares at a premium of ` 40 each.
CALCULATE the additional capital can be raised, keeping in mind that the
management wants to maximise the earnings per share to maintain its goodwill. The
company is paying income tax at 50%.
SOLUTION
Calculation of Earnings per share under the three options:
Particulars
Options
Option I:
Issue Equity
shares only
Option II: Issue
16%
Debentures
only
Option III:
Issue Equity
Shares and
16%
Debentures
of equal
amount
Number of Equity Shares
(nos):
10,00,000 10,00,000 10,00,000
- Existing
- Newly issued 2,00,000
 `50,00,000 
 
 `(10+15) 
--- 50,000
 `25,00,000 
 `(10+40) 
 
Total 12,00,000 10,00,000 10,50,000
16% Debentures ` --- 50,00,000 25,00,000
` ` `
Profit Before Interest and
Tax:
- Existing pre-tax profit 60,00,000 60,00,000 60,00,000
- From new projects 40,00,000 40,00,000 40,00,000
1,00,00,000 1,00,00,000 1,00,00,000
5.33

Less: Interest on 16%
Debentures
--- 8,00,000
(16%`50,00,000)
4,00,000
(16% ×
`25,00,000)
Profit Before Tax 1,00,00,000 92,00,000 96,00,000
Tax at 50% 50,00,000 46,00,000 48,00,000
Profit After Tax 50,00,000 46,00,000 48,00,000
Earnings Per Share (EPS)
 PAT 

No.ofShares


 
4.17
 ` 50,00,000 
 12,00,000 
 
4.60
 `46,00,000 
 10,00,000 
 
4.57
 `48,00,000 
 10,50,000 
 
Advise: Option II i.e. issue of 16% Debentures is most suitable to maximize the
earnings per share.
ILLUSTRATION 12
Shahji Steels Limited requires ` 25,00,000 for a new plant. This plant is expected to
yield earnings before interest and taxes of ` 5,00,000. While deciding about the
financial plan, the company considers the objective of maximizing earnings per share.
It has three alternatives to finance the project - by raising debt of ` 2,50,000 or `
10,00,000or ` 15,00,000 and the balance, in each case, by issuing equity shares. The
company's share is currently selling at ` 150, but is expected to decline to ` 125 in
case the funds are borrowed in excess of ` 10,00,000. The funds can be borrowed at
the rate of 10 percent upto ` 2,50,000, at 15 percent over ` 2,50,000 and upto `
10,00,000 and at 20 percent over ` 10,00,000. The tax rate applicable to the company
is 50 percent. ANALYSE which form of financing should the company choose?
SOLUTION
Plan I= Raising Debt of ` 2.5 lakh + Equity of ` 22.5 lakh.
Plan II = Raising Debt of ` 10 lakh + Equity of ` 15 lakh.
Plan III = Raising Debt of ` 15 lakh + Equity of ` 10 lakh.
Calculation of Earnings per share (EPS):
Particulars
FINANCIAL PLANS
Plan I Plan II Plan III
` ` `
Expected EBIT 5,00,000 5,00,000 5,00,000
Less: Interest (a)
(25,000) (1,37,500) (2,37,500)
5.34

Earnings before taxes 4,75,000 3,62,500 2,62,500
Less: Taxes @ 50% (2,37,500) (1,81,250) (1,31,250)
Earnings after taxes (EAT) 2,37,500 1,81,250 1,31,250
Number of shares (b)
15,000 10,000 8,000
Earnings per share (EPS) 15.83 18.13 16.41
Financing Plan II (i.e. Raising debt of `10 lakh and issue of equity share capital of
`15 lakh) is the option which maximises the earnings per share.
Working Notes:
(a) Calculation of interest on Debt.
Plan I (`2,50,000  10%) ` 25,000
Plan II (`2,50,000  10%) ` 25,000
`1,37,500
(`7,50,000  15%) `1,12,500
Plan III (`2,50,000  10%) ` 25,000
(`7,50,000  15%) `1,12,500
(`5,00,000  20%) `1,00,000 `2,37,500
(b) Number of equity shares to be issued
Plan I:
Plan II:
Plan III:
` 22,50,000
=15,000 shares
`150 (Market price of share)
` 15,00,000
=10,000 shares
`150
` 10,00,000
= 8,000 shares
`125
ILLUSTRATION 13
The following data are presented in respect of Quality Automation Ltd.:
Amount (`)
Profit before interest and tax 52,00,000
Less : Interest on debentures @ 12% 12,00,000
Profit before tax 40,00,000
5.35

Debt+Equity
Less : Income tax @ 50% 20,00,000
Profit After tax 20,00,000
No. of equity shares (of ` 10 each) 8,00,000
EPS 2.5
P/E Ratio 10
Market price per share 25
The company is planning to start a new project requiring a total capital outlay
of ` 40,00,000. You are informed that a debt equity ratio (D/D+E) higher than 35%
push the Ke up to 12.5% means reduce PE ratio to 8 and rises the interest rate on
additional amount borrowed at 14%. FIND OUT the probable price of share if:
(i) the additional funds are raised as a loan.
(ii) the amount is raised by issuing equity shares.
(Note : Retained earnings of the company is ` 1.2 crore)
SOLUTION
In this question EBIT after proposed extension is not given. Therefore, we can
assume that existing return on capital employed will be maintained.
Working notes:
1. Return on Capital Employed 
EBIT
=
Capital Employed
Capital Employed = Debt + Equity
`52,00,000
=17.33%
`3,00,00,000
= 1,00,00,000 + (80,00,000 + 1,20,00,000) = ` 3,00,00,000
2. Proposed EBIT = Proposed Capital Employed x Return on capital employed
= (3,00,00,000 + 40,00,000) x 17.33% = ` 58,92,200
(if you take return on capital employed in full digits then accurate EBIT will
be 58,93,333)
3. Debt Equtiy ratio= Debt
Option1: Loan option
Debt = 1,00,00,000 + 40,00,000 = `1,40,00,000
5.36

Equity = ` 2,00,00,000
Debt Equtiy ratio=
1.4 cr.
1.4 cr.+2 cr.
=41.18%
Debt equity ratio has crossed the limit of 35% hence PE ratio in this case will
be 8 times and additional borrowing will be at the rate of 14%
Option2: Equity option
Debt = 1,00,00,000
Equity = 2,00,00,000 + 40,00,000 = `2,40,00,000
Debt Equtiy ratio=
1 cr.
1 cr.+2.4 cr.
=29.41%
Debt equity ratio has not crossed the limit of 35% hence PE ratio in this case
will remain at 10 times.
4. Number of equity shares to be issued in case of equity option@ `25 per share
= `40,00,000 / `25 = 1,60,000
Calculation of EPS
and MPS under two
financial options
Particulars
Financial Options
Option I Option II
14% additional
loan of 40,00,000(`)
8,00,000equity share @
`10 i.e 1,60,000 equity
shares @25(`)
Profit before interest
and Tax (PBIT))
58,92,200 58,92,200
Less: Interest on old
debentures @12%
12,00,000 12,00,000
Less: Interest on
additional loan(new)
@ 14% on ` 40,00,000
5,60,000 Nil
Profit before tax 41,32,200 46,92,000
Less: Taxes @ 50% 20,66,100 23,46,100
Earnings for equity
shareholders
(EAT/Profit after tax)
20,66,100 23,46,100
Number of Equity 8,00,000 9,60,000
5.37

Shares
Earnings per Share
(EPS)
2.58 2.44
Price/ Earnings ratio 8 10
Probable per share
(MPS)
20.66 24.44
Decision: Though loan option has higher EPS but equity option has higher
MPS therefore company should raise additional fund through equity option.
5.6 OVER-CAPITALISATION AND UNDER -
CAPITALISATION
5.6.1 Over- Capitalisation
It is a situation where a firm has more capital than it needs or in other words assets
are worth less than its issued share capital, and earnings are insufficient to pay
dividend and interest. This situation mainly arises when the existing capital is not
effectively utilized on account of fall in earning capacity of the company while
company has raised funds more than its requirements. The chief sign of over-
capitalisation is the fall in payment of dividend and interest leading to fall in value
of the shares of the company.
Causes of Over-Capitalisation: Over-capitalisation arises due to following
reasons:
(i) Raising more money through issue of shares or debentures than company
can employ profitably.
(ii) Borrowing huge amount at higher rate than rate at which company can earn.
(iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution
of dividends at a higher rate.
(v) Wrong estimation of earnings and capitalisation.
Consequences of Over-Capitalisation: Over-capitalisation results in the following
consequences:
(i) Considerable reduction in the rate of dividend and interest payments.
(ii) Reduction in the market price of shares.
5.38

(iii) Resorting to “window dressing”.
(iv) Some companies may opt for reorganization. However, sometimes the matter
gets worse and the company may go into liquidation.
Remedies for Over-Capitalisation: Following steps may be adopted to avoid the
negative consequences of over-capitalisation:
(i) Company should go for thorough reorganization.
(ii) Buyback of shares.
(iii) Reduction in claims of debenture-holders and creditors.
(iv) Value of shares may also be reduced. This will result in sufficient funds for the
company to carry out replacement of assets.
5.6.2 Under Capitalisation
It is just reverse of over-capitalisation. It is a state, when its actual capitalisation is
lower than its proper capitalisation as warranted by its earning capacity. This
situation normally happens with companies which have insufficient capital but large
secret reserves in the form of considerable appreciation in the values of the fixed
assets not brought into the books.
Consequences of Under-Capitalisation: Under-capitalisation results in the
following consequences:
(i) The dividend rate will be higher in comparison to similarly situated
companies.
(ii) Market value of shares will be higher than value of shares of other similar
companies because their earning rate being considerably more than the
prevailing rate on such securities.
(iii) Real value of shares will be higher than their book value.
Effects of Under-Capitalisation: Under-capitalisation has the following effects:
(i) It encourages acute competition. High profitability encourages new
entrepreneurs to come into same type of business.
(ii) High rate of dividend encourages the workers’ union to demand high wages.
(iii) Normally common people (consumers) start feeling that they are being
exploited.
(iv) Management may resort to manipulation of share values.
5.39

(v) Invite more government control and regulation on the company and higher
taxation also.
Remedies: Following steps may be adopted to avoid the negative consequences
of under capitalization:
(i) The shares of the company should be split up. This will reduce dividend per
share, though EPS shall remain unchanged.
(ii) Issue of Bonus Shares is the most appropriate measure as this will reduce
both dividend per share and the average rate of earning.
(iii) By revising upward the par value of shares in exchange of the existing shares
held by them.
5.6.3 Over-Capitalisation vis-à-vis Under-Capitalisation
From the above discussion it can be said that both over capitalisation and under
capitalisation are not good. However, over capitalisation is more dangerous to the
company, shareholders and the society than under capitalisation. The situation of
under capitalisation can be handled more easily than the situation of over-
capitalisation. Moreover, under capitalisation is not an economic problem but a
problem of adjusting capital structure. Thus, under capitalisation should be
considered less dangerous but both situations are bad and every company should
strive to have a proper capitalisation.
SUMMARY
 Capital Structure: Capital structure refers to the mix of a firm’s capitalisation
(i.e. mix of long term sources of funds such as debentures, preference share
capital, equity share capital and retained earnings for meeting total capital
requirement). While choosing a suitable financing pattern, certain factors like
cost, risk, control, flexibility and other considerations like nature of industry,
competition in the industry etc. should be considered
 Capital Structure Theories:- The following approaches explain the
relationship between cost of capital, capital structure and value of the firm:
Net income approach
Net operating income approach
Modigliani-Miller approach
Traditional approach
5.40

ntrol.
Co
So
Trade-off Theory
Pecking Order Theory
 Optimal Capital Structure (EBIT-EPS Analysis): The basic objective of
financial management is to design an appropriate capital structure which can
provide the highest earnings per share (EPS) over the firm’s expected range
of earnings before interest and taxes (EBIT). PS measures a firm’s performance
for the investors. The level of EBIT varies from year to year and represents the
success of a firm’s operations. EBIT-EPS analysis is a vital tool for designing
the optimal capital structure of a firm. The objective of this analysis is to find
the EBIT level that will equate EPS regardless of the financing plan chosen.
 Over Capitalisation : It is a situation where a firm has more capital than it
needs or in other words assets are worth less than its issued share capital,
and earnings are insufficient to pay dividend and interest.
 Under Capitalisation : It is just reverse of over-capitalisation. It is a state, when
its actual capitalization is lower than its proper capitalization as warranted by
its earning capacity
TEST YOUR KNOWLEDGE
MCQs based Questions
1. The assumptions of M-M hypothesis of capital structure do not include the
following;
(a) Capital markets are imperfect
(b) Investors have homogeneous expectations
(c) All firms can be classified into homogeneous risk classes
(d) The dividend-payout ratio is cent percent, and there is no corporate tax
2. Which of the following is irrelevant for optimal capital structure?
(a) Flexibility,
(b)
(c)
(d)
3. Fin
(a)
lvency,
Liquidity,
l Structure refer to
All Financial resources,
5.41
ancia

e cos
(b) Short-term funds,
(c) Long-term funds
(d) None of these.
4. An EBIT-EPS indifference analysis chart is used for
(a) Evaluating the effects of business risk on EPS
(b) Examining EPS results for alternative financial plans at varying EBIT
levels
(c) Determining the impact of a change in sales on EBIT
(d) Showing the changes in EPS quality over time
5. The term "capital structure" means
(a) Long-term debt, preferred stock, and equity shares.
(b) Current assets and curr
(c) Net working capital
(d) Shareholders' equity.
6. Th t of monitoring management is considered to be a (an):
(a) Bankruptcy cost.
(b) Transaction cost.
(c) Agency cost.
(d) Institutional cost.
7. The traditional approach towards the valuation of a firm assumes:
(a) That the overall capitalization rate changes in financial leverage.
(b) That there is an optimum capital structure.
(c) That total risk is not changed with the changes in the capital structure.
(d) That markets are perfect.
8. Market values are often used in computing the weighted average cost of
capital because
(a) This is the simplest way to do the calculation.
(b) This is consistent with the goal of maximizing shareholder value.
(c) This is required by SEBI.
5.42
ent liabilities.

(d) This is a very common mistake.
9. A firm's optimal capital structure:
(a) Is the debt-equity ratio that results in the minimum possible weighted
average cost of capital.
(b) 40 percent debt and 60 percent equity.
(c) When the debt-equity ratio is .50.
(d) When Cost of equity is minimum
10. Capital structure of a firm influences the
(a) Risk.
(b) Return
(c) Both Risk and Return.
(d) Return but not Risk
Theoretical based Questions
1. DESCRIBE Capital Structure.
2. EXPLAIN in brief the assumptions of Modigliani-Miller theory.
3. DESCRIBE Net Operating Income (NOI) theory of capital structure? EXPLAIN
the assumptions of Net Operating Income approach theory of capital
structure.
4. EXPLAIN the principles of “Trading on equity”.
5. DISCUSS the concept of Debt-Equity or EBIT-EPS indifference point, while
determining the capital structure of a company.
6. DISCUSS financial break-even and EBIT-EPS indifference analysis.
Practical Problems
1. Ganesha Limited is setting up a project with a capital outlay of ` 60,00,000. It
has two alternatives in financing the project cost.
Alternative-I : 100% equity finance by issuing equity shares of ` 10 each
Alternative-II : Debt-equity ratio 2:1 (issuing equity shares of ` 10 each)
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is
40%. CALCULATE the indifference point between the two alternative methods
of financing.
5.43

T is `
2 . Ganapati Limited is considering three financing plans. The key information is
as follows:
(a) Total investment to be raised ` 2,00,000
(b) Plans of Financing Proportion:
Plans Equity Debt Preference Shares
A 100% - -
B 50% 50% -
C 50% - 50%
(c) Cost of debt 8%
Cost of preference shares 8%
(d) Tax rate 50%
(e) Equity shares of the face value of ` 10 each will be issued at a premium
of ` 10 per share.
(f) Expected EBI 80,000.
You are required to DETERMINE for each plan: -
(i) Earnings per share (EPS)
(ii) The financial break-even point.
(iii) Indicate if any of the plans dominate and compute the EBIT range
among the plans for indifference.
3. Yoyo Limited presently has `36,00,000 in debt outstanding bearing an interest
rate of 10 per cent. It wishes to finance a `40,00,000 expansion programme
and is considering three alternatives: additional debt at 12 per cent interest,
preference shares with an 11 per cent dividend, and the issue of equity shares
at `16 per share. The company presently has 8,00,000 shares outstanding and
is in a 40 per cent tax bracket.
(a) If earnings before interest and taxes are presently `15,00,000,
DETERMINE earnings per share for the three alternatives, assuming no
immediate increase in profitability?
(b) ANALYSE which alternative do you prefer? COMPUTE how much would
EBIT need to increase before the next alternative would be best?
5.44

4. Alpha Limited requires funds amounting to `80 lakh for its new project. To
ra ise the funds, the company has following two alternatives:
(i) To issue Equity Shares of `100 each (at par) amounting to `60 lakh and
borrow the balance amount at the interest of 12% p.a.; or
(ii) To issue Equity Shares of `100 each (at par) and 12% Debentures in
equal proportion.
The Income-tax rate is 30%.
IDENTIFY the point of indifference between the available two modes of
financing and state which option will be beneficial in different situations.
5. One-third of the total market value of Sanghmani Limited consists of loan
stock, which has a cost of 10 per cent. Another company, Samsui Limited, is
identical in every respect to Sanghmani Limited, except that its capital
structure is all-equity, and its cost of equity is 16 per cent. According to
Modigliani an
COMPUTE the
we ignored taxation and tax relief on debt capital,
uity of Sanghmani Limited?
ANSWERS/SOLUTIONS
Answers to the MCQs based Questions
1. (a) 2. (b) 3. (a) 4 (b) 5 (a) 6. (c)
7. (b) 8. (b) 9. (a) 10 (c)
Answers to Theoretical based Questions
1. Please refer paragraph 5.1
2. Please refer paragraph 5.2.4
5. Please refer paragraph 5.5
5.45
r, if
of eq
d Mille
cost

Answers to Practical problems
1. Calculation of Indifference point between the two alternatives of
financing.
Alternative-I By issue of 6,00,000 equity shares of `10 each amounting
to `60 lakhs. No financial charges are involved.
Alternative-II By raising the funds in the following way:
Debt = `40 lakhs
Equity = `20 lakhs (2,00,000 equity shares of `10 each)
Interest payable on debt = 40,00,000
18
100
= `7,20,000
The difference point between the two alternatives is calculated by:
(EBIT -I1) (1- T)
=
(EBIT -I2 ) (1- T)
E1 E2
Where,
EBIT = Earnings before interest and taxes
I1 = Interest charges in Alternative-I
I2 = Interest charges in Alternative-II
T = Tax rate
E1 = Equity shares in Alternative-I
E2 = Equity shares in Alternative-II
Putting the values, the break-even point would be as follows:
(EBIT 0)(10.40)

(EBIT 7,20,000) (10.40)
6,00,000 2,00,000
(EBIT)(0.60)

(EBIT 7,20,000) (0.60)
6,00,000 2,00,000
EBIT(0.60)

0.60(EBIT  7,20,000)
3 1
EBIT = 3EBIT21,60,000
2 EBIT = 21,60,000
5.46

EBIT =
21,60,000
2
EBIT = `10,80,000
Therefore, at EBIT of `10,80,000 earnings per share for the two
alternatives is equal.
2. (i) Computation of Earnings per share (EPS)
Plans A B C
Earnings before interest
and tax (EBIT)
80,000 80,000 80,000
Less: Interest charges --- (8,000)
(8% × `1 lakh)
---
Earnings before tax (EBT) 80,000 72,000 80,000
Less: Tax (@ 50%) (40,000) (36,000) (40,000)
Earnings after tax (EAT) 40,000 36,000 40,000
Less: Preference Dividend --- --- (8,000)
(8% × `1 lakh)
Earnings available for
Equity shareholders (A)
40,000 36,000 32,000
No. of Equity shares (B) 10,000
(`2 lakh ÷
`20)
5,000
(`1 lakh ÷ `20)
5,000
(`1 lakh ÷
`20)
EPS ` [(A) ÷ (B)] 4 7.20 6.40
(ii) Calculation of Financial Break-even point
Financial break-even point is the earnings which are equal to the fixed finance
charges and preference dividend.
Plan A : Under this plan there is no interest or preference dividend
payment hence, the Financial Break-even point will be zero.
Plan B : Under this plan there is an interest payment of `8,000 and no
preference dividend, hence, the Financial Break-even point will
be `8,000 (Interest charges).
Plan C : Under this plan there is no interest payment but an after tax
preference dividend of `8,000 is paid. Hence, the Financial Break-
even point will be before tax earnings of `16,000 (i.e. `8,000 ÷ 0.5
= `16,000.)
5.47

of eq
(iii) Computation of indifference point between the plans.
The indifference between two alternative methods of financing is calculated
by applying the following formula.
(EBIT I1 )(1 T)

(EBIT I2 )(1 T)
E1 E2
Where,
EBIT = Earnings before interest and tax.
I1 = Fixed charges (interest or pref. dividend) under Alternative
I2 = Fixed charges (interest or pref. dividend) under Alternative
T = Tax rate
= No. uity shares in Alternative 1
E2 = No. of equity shares in Alternative 2
Now, we can calculate indifference point between different plans of financing.
I. Indifference point where EBIT of Plan A and Plan B is equal.
(EBIT 0)(10.5)
=
10,000
0.5 EBIT (5,000) =
0.5 EBIT =
0.5 EBIT =
EBIT =
(EBIT 8,000)(10.5)
5,000
(0.5 EBIT – 4,000) (10,000)
EBIT – 8,000
8,000
`16,000
II. Indifference point where EBIT of Plan A and Plan C is equal.
(EBIT-0)(1-0.5)
10,000
0.5EBIT
10,000
=
(EBIT-0)(1-0.5)-8,000
5,000
=
0.5EBIT-8,000
5,000
0.25 EBIT = 0.5 EBIT – 8,000
0.25 EBIT = 8,000
EBIT = ` 32,000
5.48
E1

III. Indifference point where EBIT of Plan B and Plan C are equal.
(EBIT 8,000)(10.5)
5,000
=
(EBIT-0)(1-0.5)-8,000
5,000
0.5 EBIT – 4,000 = 0.5 EBIT – 8,000
There is no indifference point between the financial plans B and C.
It can be seen that Financial Plan B dominates Plan C. Since, the financial
break-even point of the former is only `8,000 but in case of latter it is `16,000.
Further EPS of plant B is the highest.
3. (a)
Particulars
Alternative–
I : Take
additional
Debt
Alternatives
Alternative-
II: Issue 11%
Preference
Shares
Alternative-
III: Issue fur-
ther Equity
Shares
EBIT
Interest on Debts:
- on existing debt
@10%
- on new debt @ 12%
Profit before taxes
Taxes @ 40%
Profit after taxes
`
15,00,000
(3,60,000)
(4,80,000)
6,60,000
(2,64,000)
3,96,000
`
15,00,000
(3,60,000)
---
11,40,000
(4,56,000)
6,84,000
`
15,00,000
(3,60,000)
---
11,40,000
(4,56,000)
6,84,000
Preference shares
dividend
Earnings available to
equity Shareholders
Number of shares
Earnings per share
---
3,96,000
8,00,000
0.495
(4,40,000)
2,44,000
8,00,000
0.305
---
6,84,000
10,50,000
0.651
(b) For the present EBIT level, equity shares are clearly preferable. EBIT would
need to increase by `2,376 `1,500 = `876 before an indifference point with
5.49

1
debt is reached. One would want to be comfortably above this indifference
point before a strong case for debt should be made. The lower the probability
that actual EBIT will fall below the indifference point, the stronger the case
that can be made for debt, all other things remain the same.
4. (i) Amount = `80,00,000
Plan I = Equity of `60,00,000 + Debt of `20,00,000
Plan II = Equity of `40,00,000 + 12% Debentures of `40,00,000
Plan I: Interest Payable on Loan
= 12% × `20,00,000 = `2,40,000
Plan II: Interest Payable on Debentures
= 12% × `40,00,000 = `4,80,000
Computation of Point of Indifference
EBIT-I 1-t
E
=
1
EBIT-I
2
E
2
1-t
EBIT- `2,40,0001-0.3=
60,000
EBIT- `4,80,000 I-0.3
40,000
2 (EBIT – `2,40,000) = 3 (EBIT – `4,80,000)
2 EBIT – `4,80,000 = 3 EBIT – `14,40,000
2 EBIT – 3 EBIT = - `14,40,000 + `4,80,000
EBIT = `9,60,000
(ii) Earnings per share (EPS) under Two Situations for both the Plans
Situation A (EBIT is assumed to be `9,50,000)
Particulars Plan I Plan II
EBIT 9,50,000 9,50,000
Less: Interest @ 12% (2,40,000) (4,80,000)
EBT 7,10,000 4,70,000
Less: Taxes @ 30% (2,13,000) (1,41,000)
EAT 4,97,000 3,29,000
No. of Equity Shares 60,000 40,000
EPS 8.28 8.23
5.50


Comment: In Situation A, when expected EBIT is less than the EBIT at indifference
point then, Plan I is more viable as it has higher EPS. The advantage of EPS would
be available from the use of equity capital and not debt capital.
Situation B (EBIT is assumed to be`9,70,000)
Particulars Plan I Plan II
EBIT 9,70,000 9,70,000
Less: Interest @ 12% (2,40,000) (4,80,000)
EBT 7,30,000 4,90,000
Less: Taxes @ 30% (2,19,000) (1,47,000)
EAT 5,11,000 3,43,000
No. of Equity Shares 60,000 40,000
EPS 8.52 8.58
Comment: In Situation B, when expected EBIT is more than the EBIT at
indifference point then, Plan II is more viable as it has higher EPS. The use of
fixed-cost source of funds would be beneficial from the EPS viewpoint. In this
case, financial leverage would be favourable.
(Note: The problem can also be worked out assuming any other figure of
EBIT which is more than 9,60,000 and any other figure less than 9,60,000.
Alternatively, the answer may also be based on the factors/governing the
capital structure like the cost, risk, control, etc. Principles).
5. Here we are assuming that MM Approach 1958: Without tax, where capital structure
has no relevance with the value of company and accordingly overall cost of capital
of both levered as well as unlevered company is same. Therefore, the two
companies should have similar WACCs. Because Samsui Limited is all-equity
financed, its WACC is the same as its cost of equity finance, i.e. 16 per cent. It follows
that Sanghmani Limited should have WACC equal to 16 per cent also.
Therefore, Cost of equity in Sanghmani Ltd. (levered company) will be
calculated as follows:
Ko =
2
Ke 
1
Kd
3 3
= 16% (i.e. equal to WACC of Samsui Ltd.)
Or, 16% =
2
Ke 
1
10%
3 3
Or, Ke = 19
5.51

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