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Capital Structure and Leverage

Capital Structure Meaning


Capital Structure is the combination of Debt and Equity.
Levered Firm: which uses debt with equity.
Unlevered Firm: which does not uses debt with equity.
Principles of Capital Structure: (FRICT Analysis-
Flexibility, Risk, Income, Control and Timing)
1. Cost/Income Principle:
Ideal pattern of capital structure- Minimizes cost of
financing and maximizes earnings per share.
Cost of capital depends on the interest rate at which
payments have to be made to suppliers of funds and tax status
of such payments.

2. Risk Principle:
Risk depends upon variability in the firms’ operations. The
excessive use of debt magnifies the variability of
shareholders’ earnings and threatens the solvency of the
company.

3. Control Principle:
Capital structure should involve minimum risk of loss of
control of company.

4. Flexibility Principle:
Capital structure should be flexible. It should be possible
for company to adapt capital structure with minimum cost
and delay if required by a changed situation. Company can
fund its profitable activities whenever needed.

5. Timing Principle:
Capital structure should be feasible to implement given the
current and future conditions of capital market. It can
exploit the opportunities. The sequencing of sources of
financing is important. In periods of boom investors are
willing to part with funds and they can be attracted by
equity, during depress, steady interest income guaranteed
by debt finds many customers.

Determinants of Capital Structure


A) Characteristics of the economy
1) Tempo of Economy - If the economy is to recover and the
level of activity is expected to expand, greater weightage
accorded to flexibility. Equity is preferred here than debt.
2) State of Capital Market - Cost and availability of funds are
determined by the capital market conditions.
3) Taxation - Current taxation structure makes debt less costly
to service than equity. Significant changes in tax rate (not
expected in the near future) can affect this equation.
4) Policy of Term Financing Institutions- Restrictive changes
in the policy can make debt option less preferable.

B)Characteristics of the industry:


1) Cyclical Variation - If the industry subject to frequent
variations in sales, flexibility and risk gain more weight.
Over dependency on debt can lead to bankruptcy in years
of low activity.
2) Degree of Competition - Public sector units facing no
competition and assured of steady market and earnings
weigh cost fac1 more. Companies facing competition need
to focus on risk factor to avoid crunch during paucity of
profits.
3) Stage of Life Cycle – Companies at infant stage prefer
equity duly underwritten as a main source of funds. Thus,
risk is the guiding principle. Once the firm is established
and it starts steady earnings, it switches to cost principle
and uses debt funds.
Here also, if growth is aimed through introduction of new
products through Research & Development, equity is
preferable source in view of uncertainty as to when new
products could be put into market.
C) Characteristics of Company
1) Size of Business -
Smaller companies find it harder to obtain debt funds in view
of the poor credit worth. Common stock represents a major
portion of funds for smaller companies. As they grow and
accumulate assets, funds can be garnered from the market at
economic terms.
Larger companies exercise their choice in selecting funds at
reasonable cost with scope for flexibility for future
expansion.
Medium sized companies, in a position to obtain the entire
from a single source, leverage
Principle is given greater consideration to minimize cost of
capital.
2) Form of Business Organization - Control principle is
critical for private limited companies as ownership is closely
held.
Public limited companies need flexibility and want to
explore both equity as well as debt.
For proprietary company flexibility is not relevant as they
have access to limited sources.

3. Stability of Earnings-
Greater stability of sale & earning allows a company to rely
on leverage principle and it can undertake fixed obligation
debt with low risk
Irregular earnings demand greater reliance on risk and,
therefore, equity.
4. Asset Structure of Company –
Assets consisting of long life fixed nature allow leverage and
use of cheap debt funds. But if assets consist of inventory and
debtors, risk principle over rides cost and favour common
stock.
5. Age of Company -Young companies are not known in
capital market & have to rely on common stocks for funds
and keep options open for future maneuverability. Mature
companies with good
earnings track record can raise funds from any source they
prefer and should use leverage fully.
6. Credit Standing - Strong standing allows company adjust
sources and retain flexibility. New companies with poor
credit standing have limited choices for sources of funds.
7. Attitude of Management -
Towards control and risk needs to be studied in deciding upon
pattern of capitalization. Their desire to retain control means
funds are to be sourced from debt instruments. Directors who
are at the helm of control for long period would like to leverage
their funds.

Leverage
Leverage (Advantage): The ability to influence a system, or an
environment, in a way that multiplies the outcome of one’s
efforts without a corresponding increase in the consumption of
resources.
Two types of Leverage: 1) Financial Leverage and 2)
Operating Leverage
1) 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.
Trading on Equity means using the owners’ equity as a
basis to raise debt.
Measurement of Financial Leverage
a) Debt ratio: debt by total capital; Debt/ Debt+Equity
b) Debt-equity Ratio: Debt by equity; Debt/Equity
c) Interest Coverage: EBIT/Interest
DEBT ratio and Debt-equity ratio both rank rank
companies in the same order, as there is no difference
between both measures in operational terms.
Debt-equity ratio is more popular in practices.

2) Degree of operating leverage (DOL): The percentage


change in the earnings before interest and taxes relative
to given percentage change in sales.
DOL = % Change in EBIT/ % Change in Sales =
Contribution/EBIT
3) Degree of Financial Leverage (DFL): Percentage change
in EPS due to percentage change in EBIT
DFL = % Change in EPS/ %Change in EBIT
=EBIT/PBT
4) Combined Leverage(DCL): % Change in EPS/ %
Change in Sales = Contribution/PBT

Indifference Point or Break-even point between two


alternative methods of Financing
Level of EBIT at which EPS would be the same under two
alternative plans.
At this level rate of return on capital employed = cost of
debt
One plan all equity plan and another debt-equity plan.
(1-T)EBIT/N1= (1-T) (EBIT-INT)/N2
When Preference share is used
(1-T)EBIT/N1 = (1-T) (EBIT-INT)-PD/N2