Determinants of Capital

Structure

Name: Sneha Lotlikar

Roll No: 09-2010
1. Earning before interest and tax (EBIT) –
earning per share (EPS) analysis
 The primary objective of the financial management of maximizing
the market value of the firm the EBIT – EPS analysis should be
considered as 1st step in the direction of designing a firms capital
structure.
 Analysis is useful for two reason:
1. EPS is a measure of firm’s performance – given the P/E ratio , the
larger the EPS, larger would be the value of the firm’s share.
2. The given importance of EPS and the function of the EBIT–EPS
analysis to show the value of EPS under various financial
alternatives at different levels of EBIT.
 If the probability of EBIT falling below, the equity alternative
should be preferred.
 Higher the level of EBIT and lower the probability of downward
fluctuation, greater is the amount of debt that can be employed.
2. Coverage Ratio

 Apart from the EBIT – EPS analysis, the ability of a firm to

use debt, from the profitability point of view, can also be
judged in terms of a coverage ratios
= EBIT
I
 the ratio measure the size of the interest payments relative to
the EBIT. The reciprocal of this ratio measures the proportion
of EBIT devoted to interest payments.

 higher the coverage ratio, the greater is the certainty that the
firm would be in a position to meet its obligation of interest
payment.
3.Cash Flow Analysis:
 Cash flow ability of a company will have a direct impact on
the capital structure.
 Cash flow generation capacity of a firm increases the
flexibility of a finance manager in deciding a capital
structure.
 Cash generated by a company or availability of a continuous
supply of cash increases the reputation of the company.
 Cash flow permits the company to meet its short term
obligations.
 A firm will have an obligation to pay dividend to equity share
holders, interest to bankers and debenture holders.
 Cash flow generating capacity of a company will help it in
meeting its debt commitments. Thus a sound cash flow
facilitates raising funds through debt.
 The cash flow analysis establishes the debt capacity by
examining the probability of default.
 The cash flow approach to assessing debt involves the
following steps:
 Specify a tolerance limit on the possibility of default.
 Estimate the probability of cash flows, taking into account the
projected performance of the firm.
 Calculate the fixed charges by way of interest payment and
principal repayment associated with various levels of debt.
 Estimate the debt capacity of the firm, which is the highest
level of debt which is acceptable, based on the above
mentioned parameters.
4. Control
 Control is related with the ownership in the Company.
 Its attitude of management toward the control.
 The main objective of the management is to maintain control
– greater weightage for debt and preference shares.
 If the company has too much of equity then there will be the
dilution of control.
 More equity means more voting rights and more control over
the management
 Control

If the Shareholders' Base increases - > Dilution of Control

5. Leverage ratios for other firms
in the industry
 A comparison with the debt – equity ratio of the companies
belonging to the same industry.

 Comparison is helpful as it acts as a red signal to the

management that there may be something wrong with the
debt – equity mix of the company.
6. Nature of industry
 Nature of industry is an another important element in
determining the degree of financial leverage of a firm.
 If an industry’s sales are fluctuating then the firm should have
a low degree of financial leverage. E.g. Like automobile
industries, electronic goods.
 Such firm should rely less on the debt.
 On the hand, if an industry’s sales are not fluctuating and
there is demand for a product. For e.g. FMCG
 Such industries can afford to have higher Debt proportion in
capital structure.
 Industry’s with a competitive nature should have greater
proportion of equity than debt
 E.g. GARMENT INDUSTRY
7. Consultation with investment bankers
and lenders
 Another useful approach in deciding the proportion of debt –
equity ratio in a firm’s structure is to seek the opinion of
investment analysts, institutional investors, investment
bankers and lenders.

 These analysts, having been in business for long period of

time, they are the expertise and have access to information
regarding securities of a large number of companies and
know how the market evaluates them.
8. Maintaining maneuverability for commercial
strategy
 Maneuverability refers to a firm’s ability its sources of funds
in either direction- increase or decrease in response to change
the need for funds.
 Flexibility:- Firms Ability to adapt its Capital Structure
to Changing Situations/conditions
 Here the finance manager must be in such a situation where
he can change the position.
 For instance, if the firm adopt aggressive debt policy as it will
look good at one point but if the firm is in need of additional
funds in the future it will be forced to issue equity shares.
9. Timing of issue
 It is closely related to flexibility in deciding the types of
funds to be used. It is the question of timing.
 The timing of the public offerings is also an important
considerations in capital structure decisions of a firms.
 Public offering should be made at a time when the state of
economy and capital market is booming.
 Government policies with timing of issue.
 Type of policy pursued by the govt. reflects itself in prices as
well as debt and equity.
 High debentures yields are associated with relative scarcity of
debt money and low P/E ratios on share are the indication of
the relative scarcity of equity funds.
10. Characteristics of the company

 The characteristics of the company in term of size and credit

standing determine the share of senior security and equity in
its capital structure.
 Generally, the investor believe that small scale industries are
more risky than the large firms so they prefer to invest in
large scale industries therefore this industries are not able to
raise funds from different sources so their ability to raise fund
is limited as compare to the large scale industries.
 These large scale industries has good credit standing among
the investor/lenders in the capital market.
 Such firms can easily from the sources of their choice. If the
credit standing is poor, the firms choice of obtaining fund is
very limited.
11. Tax planning
 Tax planning is likely to have a significant bearing on capital
structure decisions.
 Under Income Tax Act 1961, while interest on borrowed
funds is allowed as deduction.
 Under section 36(1)(iii) dividend on shares is not deductible.
 Whenever company has to pay dividend it has to pay tax on
it.
THANK YOU