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Capital Structure Defined
The term capital structure is used to represent the proportionate relationship
between debt and equity.
The various means of financing represent the financial structure of an enterprise.
The left-hand side of the balance sheet (liabilities plus equity) represents the
financial structure of a company. Traditionally, short-term borrowings are excluded
from the list of methods of financing the firm’s capital expenditure.
Questions while Making the Financing Decision
How should the investment project be financed?
Does the way in which the investment projects are financed matter?
How does financing affect the shareholders’ risk, return and value?
Does there exist an optimum financing mix in terms of the maximum value to the
firm’s shareholders?
Can the optimum financing mix be determined in practice for a company?
What factors in practice should a company consider in designing its financing
policy?
Features of An Appropriate Capital Structure
capital structure is that capital structure at that level of debt – equity proportion
where the market value per share is maximum and the cost of capital is minimum.
Appropriate capital structure should have the following features
Profitability / Return
Solvency / Risk
Flexibility
Conservation / Capacity
Control
Determinants of Capital Structure Seasonal Variations
Tax benefit of Debt
Flexibility
Control
Industry Leverage Ratios
Agency Costs
Industry Life Cycle
Degree of Competition
Company Characteristics
Requirements of Investors
Timing of Public Issue
Timing of Public Issue
Legal Requirements
Patterns / Forms of Capital Structure
Following are the forms of capital structure:
Complete equity share capital;
Different proportions of equity and preference share capital;
Different proportions of equity and debenture (debt) capital and
Different proportions of equity, preference and debenture (debt) capital.
Approaches to Determine Appropriate Capital Structure
EBI T – EPS Approach – This approach is helpful to analyze the impact of debt
on earnings per share.
Valuation Approach – This approach determines the impact of debt use on the
share holders value and
Cash Flow Approach - This approach analyses the firm’s debt service capacity
Meaning of Financial Leverage
The use of the fixed-charges sources of funds, such as debt and preference
capital along with the owners’ equity in the capital structure, is described as
financial leverage or gearing or trading on equity.
The financial leverage employed by a company is intended to earn more
return on the fixed-charge funds than their costs. The surplus (or deficit) will
increase (or decrease) the return on the owners’ equity. The rate of return on
the owners’ equity is levered above or below the rate of return on total
assets.
Measures of Financial Leverage
Debt ratio
Debt–equity ratio
Interest coverage
The first two measures of financial leverage can be expressed either in terms
of book values or market values. These two measures are also known as
measures of capital gearing.
The third measure of financial leverage, commonly known as coverage ratio.
The reciprocal of interest coverage is a measure of the firm’s income gearing.
Financial Leverage of Ten Largest Indian Companies, 2006Company Capital Gearing Income Gearing
Debt ratio Debt–equity ratio Interest coverage Interest to EBIT ratio
1. Indian Oil 0.556 1.25:1 4.00 0.250
2. HPCL 0.350 0.54:1 5.15 0.194
3. BPCL 0.490 0.96:1 5.38 0.186
4. SAIL 0.858 6.00:1 - ve - ve
5. ONGC 0.106 0.12:1 53.49 0.019
6. TELCO 0.484 0.94:1 0.99 1.007
7. TISCO 0.577 1.37:1 1.62 0.616
8. BHEL 0.132 0.15:1 8.36 0.120
9. Reliance 0.430 0.75:1 3.46 0.289
10. L&T 0.522 1.09:1 2.31 0.433
11. HLL 0.027 0.03:1 264.92 0.004
12. Infosys 0.000 0.00:1 NA* NA*
13. Voltas 0.430 0.72:1 2.64 0.378
Operating Leverage
Operating leverage may be defined as the firm’s ability to use operating costs to
magnify the effects of changes in sales on its earnings before interest and taxes.
Operating leverage is associated with investment (assets acquisition) activities.
How to calculate OL?
The degree of operating leverage may be defined as the change in the
percentage of operating income (EBIT), for the change in percentage of sales
revenue. The degree of operating leverage at any level of output is arrived at by
dividing the percentage change in EBIT with percentage change in sales. (15) That
is
Degree of Operating Leverage (DOL) = Percentage change in EBIT / Percentage
change in sales
Or
DOL=Contribution / Operating profit (EBIT)
Impact of OL
Operating leverage may be favorable or unfavourable. High degree of operating
leverage indicates that high degree of risk. It is good when revenues are rising and
bad when they are falling.
Operating risk (business risk) is the risk of the firm not being able to cover its fixed
operating costs. The larger the magnitude, the larger the volume of sales required
to cover all fixed costs.
Application of Operating Leverage
It is helpful to know how operating profit (EBIT) would change with
a given change in units produced.
It will helpful in measuring business risk.
Financial Leverage
financial leverage is the ability of the firm to use fixed financial charges to
magnify the effects of changes in EBIT on the firm’s earnings per share.
In other words, financial leverage may be defined as the payment of fixed rate of
interest for the use of fixed interest bearing securities to magnify the rate of
return as equity shares
Financial leverage in computed by the following formula
Financial Leverage = EBIT or operating profit divided by EBT or taxable income
Or
Degree of financial leverage (DFL)= Percentage change in EPS divided by
Percentage change in EBIT
Impact of FL Financial leverage may be positive or negative favorable leverage occurs when the
firm earns more on the assets purchased with the funds, than the fixed cost of their
use and vice versa. Higher the degree of financial leverage leads to high financial
risk.
The financial risk refers to the risk of the firm not being able to cover its fixed
financial costs. Hence, financial manager should take into consideration the level
of EBIT and fixed charges while preparing the firm’s financial plan.
Combined Leverage
The degree of combined leverage may be defined as the percentage change in
EPS due to the percentage change in sales.
Thus the combined leverage is:
% Change in EBIT / % change in sales * % Change in EPS/ % Change in EBIT
= % change in EPS / % Change sales
Or
Contribution / EBT (OR) FL*OL
Impact of CL
The combined leverage can work in both directions. It is favorable if sales increase
and unfavourable when sales decrease.
This is because the change in sales results in more than proportion returns in the
form of EPS. Financial leverage and operating leverage are something like double-
edged sword.
They have tremendous acceleration or deceleration effects on EBIT and EPS. A right
combination of these leverage is blessing for corporate growth, while an improper
combination may prove as a curse. Operating leverage also acts as a check on
financial leverage.
Financial Leverage and the Shareholders’ Return
The primary motive of a company in using financial leverage is to magnify the
shareholders’ return under favourable economic conditions. The role of financial
leverage in magnifying the return of the shareholders’ is based on the
assumptions that the fixed-charges funds (such as the loan from financial
institutions and banks or debentures) can be obtained at a cost lower than the
firm’s rate of return on net assets (RONA or ROI).
EPS, ROE and ROI are the important figures for analysing the impact of
financial leveraged