CAPITAL STRUCTURE DECISION

Business risk is the risk inherent in the operations of the firm, prior to the financing decision. Thus, business risk is the uncertainty inherent in a total risk sense, future operating income, or earnings before interest and taxes (EBIT). Business risk is caused by many factors. Two of the most important are sales variability and operating leverage.

Financial risk is the risk added by the use of debt financing. Debt financing increases the variability of earnings before taxes (but after interest); thus, along with business risk, it contributes to the uncertainty of net income and earnings per share. Business risk plus financial risk equals total corporate risk.

OUTLINE

• ....• EBIT – EPS Analysis• ROI – ROE Analysis• Ratio Analysis• Leverage Analysis• Cash Flow Analysis• Comparative Analysis• Guidelines for Capital Structure Planning• Capital Structure Policies in Practice

EBIT – EPS ANALYSIS

The relationship between EBIT and EPS is as follows:

(EBIT – I) (1 – t)

EPS = n

BREAK-EVEN EBIT LEVEL/POINT OF

INDIFFERENCE

There is a point of EBIT at which two Financing options provide the same amount of EPS for shareholders. It can be derived from the following equation:

(EBIT*-I1) (1-T) = (EBIT*-I2) (1-T)n1 n2

If the level of EBIT for the point of indifference is relatively low and managers are fairly confident of achieving that level, then the firm may decide to use an increased level of leverage to maximize EPS, which in turn maximises shareholders’ wealth. Otherwise it is advisable to decide the financing structure in favour of equity.

ROI – ROE ANALYSIS

ROE = [ROI + (ROI – r) D/E] (1 – t)

where ROE = return on equity

ROI = return on investment

r = cost of debt

D/E = debt-equity ratio

t = tax rate

LEVERAGE ANALYSIS

• There are two kinds of leverage, viz., operating leverage and

financial leverage.

• Operating leverage arises from the firm’s fixed operating

costs. Rent Expenditure, Insurance expenditure, etc.

• Financial leverage arises from the firm’s fixed financing

costs. Interest on Debt

INCOME STATEMENT FORMAT

SalesOperating Less: Variable costs leverage Less: Fixed operating costs

Contribution before interest and tax Less: Interest on debt Total

Profit before tax leverage

Financial Less: Taxleverage Profit after tax

Less: Preferred dividend Equity earnings

CERTAIN RELATIONSHIPS

PBIT = Q (P – V) – F

PAT = (PBIT – I) ( 1 – T)

EPS =(PBIT – I) (1 – T) – Dp

N

= [Q (P – V) – F – I] (1 – T) – Dp

N

OPERATING LEVERAGE

The sensitivity of profit before interest and taxes (PBIT) to

changes in unit sales is referred to as the degree of operating

leverage (DOL).

DOL = Δ PBIT/PBIT

Δ Q / Q

=Q (P – V)

=Contribution

Q (P – V) – F Profit before interest and tax

FINANCIAL LEVERAGE

The sensitivity of profit before tax (or profit after tax or earnings

per share) to changes in PBIT is referred to as the degree of

financial leverage.

DFL = Δ PBT / PBT = PBITΔ PBIT / PBIT PBIT – I

= Profit before interest and tax

Profit before tax

TOTAL LEVERAGE/Combined Leverage

The sensitivity of profit before tax (or profit after tax or earnings

per share) to changes in unit sales is referred to as the degree of

total (or combined) leverage (DTL).

DTL = Δ PBT / PBT = Q (P – V)

Δ Q / Q PBIT – T

= Contribution Profit before tax

DTL = DOL x DFL

Desirability of Financial Desirability of Financial LeverageLeverageSummery of Analysis of Financial Leverage

◦ Substitution of Equity with debt enhances earnings for equity shareholders, as cheaper debt replaces more expensive equity.

◦ As the EPS for shareholders increases, the variability of EPS too increases. In effect, this means that the shareholders are exposed to greater risk as more and more debt substitutes for equity.

◦ It can be concluded that if the level of EBIT is not sufficiently large, then it is beneficial to have less debt. The financing option with a lower amount of debt provides higher earnings per share.

Capital Structure of firmsCapital Structure of firms If sales tend to fluctuate widely, then cash flows and the

ability to service fixed charges will also vary. Such a firm is said to have high business risk. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges, and interest payments are fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations.

Public utilities place greater emphasis on long-term debt because they have more stable sales and profits as well as more fixed assets. Also, utilities have fixed assets which can be pledged as collateral.

Cont…..Cont….. Trade firms use retained earnings to a greater extent,

probably because these firms are generally smaller and, hence, have less access to capital markets.

Public utilities have lower retained earnings because they have high dividend payout ratios and a set of stockholders who want dividends.

Any financial plan today involves predictions of the future economic outlook. If these predictions can be made with a high degree of confidence, the financial manager can use debt funds in his/her operations with greater assurance. The burdens of long-term debt can be assumed with greater confidence because sales, costs, and profits are less vulnerable to fluctuations. Therefore, the ability to meet fixed financial obligations is more assured.

RATIO ANALYSIS

• Interest Coverage Ratio

Earnings before interest and taxes

Interest on debt

• Cash Flow Coverage Ratio

EBIT + Depreciation + Other non-cash charges

loan repayment installment

(1 – Tax rate) Interest on debt +

CASH FLOW ANALYSIS

The key question in assessing the debt capacity of a firm

is whether the probability of default associated with a

certain level of debt is acceptable to the management.

The cash flow analysis establishes the debt capacity by

examining the probability of default.

INVENTORY OF RESOURCES

It would be helpful to supplement cash flow analysis by estimating potential sources of liquidity available to the firm to meet possible cash drains. These sources, as suggested by Gordon Donaldson, may be divided into three categories:

• Uncommitted reserves

• Reduction of planned outlays

• Liquidation of assets

COMPARATIVE ANALYSIS

• A common approach to analysing the capital structure of a firm is to compare its debt-equity ratio to the average debt-equity ratio of the industry to which the firm belongs.

• Since the firms in an industry may differ on factors like operating risk, profitability, and tax status it makes sense to control for differences in these variables.

GUIDELINES FOR CAPITAL STRUCTURE PLANNING

• Avail of the tax advantage of debt

• Preserve flexibility

• Ensure that the total risk exposure is reasonable

• Examine the control implications of alternative financing plans

• Subordinate financial policy to corporate strategy

• Mitigate potential agency costs

GUIDELINES FOR CAPITAL STRUCTURE PLANNING

• Resort to timing judiciously

• Finance proactively not reactively

• Know the norms of lenders and credit rating agencies

• Issue innovative securities

• Widen the range of financing sources

• Communicate intelligently with investors

CAPITAL STRUCTURE POLICIES

Five common policies are:

A. No debt should be used

B. Debt should be employed to a very limited extent

C. The debt-equity ratio should be maintained around 1:1

D. The debt-equity ratio should be kept within 2:1

E. Debt should be tapped to the extent available