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Capital Structure

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Published in: Financial Management
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Capital Structure

Meera's C / Mumbai

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  1. Capital Structure Decisions & Leverage
  2. Com an Maruti Suzuki Bank of Baroda SBI ABB Whirl ool S m hon Brittania Nestle Ci la Sun Pharma Infos s TCS SAIL JSW BPCL Reliance Sector Auto Auto Bankin Bankin Infrastructure Infrastructure Consumer Durable Consumer Durable FMCG FMCG Pharma Pharma Steel Steel Oil Refiner Oil Refiner Debt 180 2620 371.07 12,299.68 0.00 0.00 4.3 19.57 1,380.61 2,409.01 250.27 28,220.72 25,761.23 11,777.28 89, 141 .00 E ult 23704 19225 39,835.35 2,811.98 37,084.58 915.78 232.74 1,235.62 2,837.21 11,090.15 7,407.88 48,068.00 45,416.44 43,504.78 25,724.60 22,467.48 Debt% 0.75 11.99 94.25 93.28 11.66 24.91 0.00 0.00 0.35 0.69 11.07 0.00 0.55 39.35 50.04 29.20 E ult o 99.25 88.01 5.75 6.72 88.34 75.09 100.00 100.00 99.65 99.31 88.93 75.46 100.00 99.45 60.65 49.96 65.61 70.80
  3. Session Outline Capital Structure Planning Approaches Cost of Capital Approach EBIT - EPS Analysis ROI - ROE Analysis Leverage Analysis Comparative Analysis Guidelines for Capital Structure Planning Capital Structure Policies in Practice
  4. Capital Structure Planning Approaches EBIT-EPS Analysis Cost of Capital Approach Capital Structure Planning ROI-ROE Analysis
  5. Cost of Capital Approach Capital Structure should be such that it minimizes the Cost of Capital
  6. Cost of capital Approach Example The management of a firm believes that the cost of equity and debt for different proportions of equity and debt in the capital structure are as follows Proportion of Equity 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 Proportion of Debt 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 Cost of Equity, 15.0 16.0 16.5 17.0 17.5 18.0 18.5 19.0 19.5 20.0 Cost of Debt, 7.0 7.5 8.0 8.5 9.0 9.5 10.0 11.0 12.0 14.0
  7. EBIT - EPS ANALYSIS The relationship between EBIT and EPS is as follows: (EBIT -1) (1 -t) EPS = n
  8. EARNINGS PER SHARE UNDER ALTERNATIVE FINANCING PLANS Equity Financing EBIT.• EBIT.• Debt Financing EBIT.• EBIT.• Interest Profit before taxes Taxes Profit after tax Number of equity shares Earnings per share 0.50 1.00 600,000 300,000 300,000 0.30 1.30
  9. BREAK-EVEN EBIT LEVEL The EBIT indifference point between two alternative financing plans can be obtained by solving the following —t) —t) equation for EBIT* (EBIT 11) (1 111 (EBIT 12) (1 112
  10. Break Even EBIT Example The profit and loss account for the year 1 (the year that has just ended) and the balance sheet at the end of year 1 for Red Rock Limited are as follows. Profit and Loss Account Rs.in crore Balance Sheet Sources of Funds Shareholders ' Funds Sales PBIT Interest PBT Tax = 30%) PAT Dividends (Rs. 3 per share) Retained Earnings Rs. in crore 300 520 86 16 70 21 49 18 31 Paid up capital . 60 (Equity shares of par value Rs. 10) Reserves and Surplus: 240 Loan Funds Application of Funds Net fixed assets Net current assets 200 500 350 150 Red Rock Limited requires Rs. 200 crore of external financing for which it is considering two alternatives: Alternative A : Issue of 1.6 crore equity shares of Rs 10 par at Rs. 125 each. Alternative B : Issue of Rs.200 crore of debentures carrying 8 percent interest rate.
  11. ROI - ROE PNALYSIS ROE = [ROI + (ROI - r) DIE] (1 —t) where ROE = ROI DIE t return on equity = return on investment = cost of debt = debt-equity ratio = tax rate
  12. ROI-ROE Analysis Example Suppose a firm requires an investment outlay of Rs. 100 million. The firm is considering two capital structures: Equity Debt Capital Structure A (Rs. In millions) 100 0 Equity Debt Capital Structure B (Rs. In millions) 50 50 While the average cost of debt is fixed at 12%, the ROI(Defmed as EBIT/Total Assets) may vary widely and is expected to be between 5% to 25%. The tax rate of the firm
  13. LEVERAGE ANALYSIS There are two kinds of leverage, viz., operating leverage and financial leverage. Operating leverage arises from the firm' s fixed operating costs. ' Financial leverage arises from the firm' s fixed financing costs.
  14. INCOME STATEMENT FORMAT Operating leverage Financial leverage Sales Less: Variable costs Less: Fixed operating costs Contribution before interest and tax Less: Interest on debt Profit before tax Less: Tax Profit after tax Less: Preferred dividend Equity earnings Total leverage
  15. CERTAIN RELATIONSHIPS PBIT PAT EPS (PBIT -1) ( -T) (PBIT -1) (1 T) T)
  16. OPERATING LEVERAGE The sensitivity of profit before interest and taxes (P BIT) to changes in unit sales is referred to as the degree of operating leverage (DOL), A PBIT/PBIT DOL Contribution Profit before interest and tax
  17. 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, A PBT / PBT DFL A PBIT / PBIT PBIT PBIT -1 Profit before interest and tax Profit before tax
  18. TOTAL 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 DTL A PBT / PBT Contribution Profit before tax DOL x DFL PBIT-T
  19. 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,
  20. 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
  21. 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
  22. 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
  23. SUMMING UP EPS = (EBIT -O (1 -t) / n , ROE = [ROI + (ROI -r) DIE] (1 -t) ' Interest coverage ratio, cash flow coverage ratio, debt service coverage ratio, and fixed assets coverage ratio are commonly employed in capital structure assessment, ' Cash flow analysis establishes the debt capacity by examining the probability of default, ' Potential sources of liquidity to a firm are : uncommitted reserves, reduction in planned outlays, and liquidation of assets. The important guidelines to be borne in mind while hammering out the capital structure policy of the firm are : avail of the tax advantage of debt; preserve flexibility; finance proactively; and communicate intelligently with investors Firms seem to pursue different capital structure policies

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