Unit 2: Capital Structure

Capital Structure

Capital Structure refers to the mix of long-term sources of finance used by a company:

• Equity Share Capital
• Preference Share Capital
• Debt (Debentures, Loans, Bonds)
• Retained Earnings

The goal is to choose the optimal capital structure that minimizes cost of capital and maximizes firm value.

Factors Affecting Capital Structure

Factor	Explanation
1. Nature of Business	Capital-intensive industries (steel, cement) use more debt; service firms use more equity.
2. Size & Growth Stage	Large and mature firms can borrow easily; new companies depend more on equity.
3. Business Risk	High-risk business → low debt. Stable business → more debt.
4. Cost of Capital	If debt is cheaper (tax benefit), firms use more debt.
5. Cash Flow Position	Strong, consistent cash flows allow higher debt servicing.
6. Control Considerations	Promoters prefer debt to avoid dilution of ownership.
7. Flexibility	Firms maintain unused debt capacity for future needs.
8. Market Conditions	In boom—issue equity; in recession—avoid equity due to low prices.
9. Regulatory Environment	Some industries have borrowing caps or capital requirements.
10. Taxation	Interest on debt is tax-deductible → encourages debt financing.

Capital Structure Theories

A. Net Income Approach (NI Approach)

• Proposed by Durand.
• Assumes cost of debt < cost of equity.
• More debt → lower overall cost of capital (Ko) → higher firm value.
• Suggests 100% debt for maximum value. (Unrealistic)

B. Net Operating Income Approach (NOI Approach)

• Also by Durand.
• Assumes overall cost of capital (Ko) remains constant.
• If debt increases, cost of equity (Ke) increases to maintain Ko.
• Capital structure does not affect firm value.

C. Traditional Approach (Intermediate Approach)

• Optimal capital structure exists.
• Initially, debt ↓ cost of capital, but after a point, excessive debt ↑ financial risk.
• U-shaped curve for cost of capital.
• Mix of equity and debt gives optimal structure.

D. Modigliani and Miller (MM) Theory

Case 1: Without Taxes

• Capital structure is irrelevant.
• Value depends only on operating income.

Case 2: With Taxes

• Interest is tax-deductible → more debt creates tax shield.
• Value increases with higher debt.
• Suggests 100% debt in theory, but unrealistic due to bankruptcy risk.

Leverages

Leverage measures how sensitive profits are to changes in sales.

A. Operating Leverage

Due to fixed operating costs (rent, salaries).

$$\text{DOL}=\frac{\mathrm{\%}\text{ change in EBIT}}{\mathrm{\%}\text{ change in Sales}}$$

High DOL → small change in sales causes large change in EBIT.

B. Financial Leverage

Due to fixed financial costs (interest).

$$\text{DFL}=\frac{\mathrm{\%}\text{ change in EPS}}{\mathrm{\%}\text{ change in EBIT}}$$

High DFL → small change in EBIT causes large change in EPS.

C. Combined Leverage

Impact of both operating and financial leverage.

$$\text{DCL}=DOL\times DFL$$

Measures total business + financial risk.

EBIT–EPS Analysis

Used to determine whether to use debt or equity financing.

Concept

• If EBIT > Break-even EBIT, debt financing gives higher EPS because interest is fixed.
• If EBIT < Break-even EBIT, equity is better.

Formula for Break-even EBIT

$${\text{EBIT}}_{BE}=\frac{\text{Interest}}{1-\frac{T}{EP{S}_{Equit\mathrm{y}}}}$$

(Simplified exam version: Break-even EBIT occurs where EPS under different financing methods are equal.)

Useful for

• Capital structure decisions
• Comparing financing plans
• Understanding effect of leverage on shareholder returns

ROI and ROE Analysis

A. ROI (Return on Investment)

Measures profitability of total capital employed.

$$ROI=\frac{EBIT}{TotalInvestment}\times 100$$

Shows operational efficiency.

B. ROE (Return on Equity)

Measures return earned only on shareholder’s funds.

$$ROE=\frac{NetProfit}{Shareholde{r}^{\mathrm{\prime }}sEquity}\times 100$$

ROE is influenced by leverage:

• If ROI > cost of debt, using debt increases ROE.
• If ROI < cost of debt, debt decreases ROE.

This is called trading on equity.

Differences: ROI vs ROE

Parameter	ROI	ROE
Meaning	Return on total capital	Return on equity only
Focus	Operational performance	Shareholder profitability
Leverage effect	Not affected	Highly affected
Formula	EBIT / Total Investment	Net Profit / Equity

Summary Quick Notes

• Capital structure = mix of debt + equity.
• Factors: risk, cost, tax, cash flow, control, market.
• Theories: NI, NOI, Traditional, MM.
• Leverages show sensitivity of profit: Operating, Financial, Combined.
• EBIT–EPS helps choose best financing mix.
• ROI measures operational efficiency; ROE measures equity returns.