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ë Say what is Capital Structure
ë Distinguish between capital structure and financial structure
ë Know the optimum capital structure
ë Highlight the features of appropriate capital structure
ë Discuss number of factors that determine a firm¶s capital structure
ë List out the forms of capital structure
ë Know EBIT-EPS analysis and their importance in establishing optimal capital
structure
ë Determine optimal capital structure based on EBIT ± EPS analysis
ë Say the meaning of point of indifference and calculate point of indifference
ë Know the meaning and types of leverages in business
ë Calculate operating leverage and break-even quantity
ë Calculate financial leverage and its impact on EPS
ë The appropriate combination of operating and financial leverage
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ë The term capital structure is used to represent the proportionate relationship
between debt and equity.
ë 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.
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ë How should the investment project be financed?
ë Does the way in which the investment projects are financed matter?
ë How does financing affect the shareholders¶ risk, return and value?
ë Does there exist an optimum financing mix in terms of the maximum value to the
firm¶s shareholders?
ë Can the optimum financing mix be determined in practice for a company?
ë What factors in practice should a company consider in designing its financing
policy?
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ë 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

ë Profitability / Return

ë Solvency / Risk

ë Flexibility

ë Conservation / Capacity

ë Control
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ë Seasonal Variations
ë Tax benefit of Debt
ë Flexibility
ë Control
ë Industry Leverage Ratios
ë Agency Costs
ë Industry Life Cycle
ë Degree of Competition
ë Company Characteristics
ë Requirements of Investors
ë Timing of Public Issue
ë Timing of Public Issue
ë Legal Requirements

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Following are the forms of capital structure:
ë Complete equity share capital;
ë Different proportions of equity and preference share capital;
ë Different proportions of equity and debenture (debt) capital and
ë Different proportions of equity, preference and debenture (debt) capital.
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 ± This approach is helpful to analyze the impact of debt
on earnings per share.
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 ± This approach determines the impact of debt use on the
share holders value and
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!perating 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.
!perating leverage is associated with investment (assets acquisition) activities.
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ë 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 !perating Leverage (D!L) = Percentage change in EBIT / Percentage

change in sales
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D!L=Contribution / !perating profit (EBIT)

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!perating 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.

!perating 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.

ë Application of !perating Leverage

ë It is helpful to know how operating profit (EBIT) would change with

a given change in units produced.

ë It will helpful in measuring business risk.

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ë 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.

ë 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
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Financial Leverage = EBIT or operating profit divided by EBT or taxable income

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Degree of financial leverage (DFL)= Percentage change in EPS divided by
Percentage change in EBIT
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ë 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.
ë 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.
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ë The degree of combined leverage may be defined as the percentage change in
EPS due to the percentage change in sales.
ë Thus the combined leverage is:
% Change in EBIT / % change in sales * % Change in EPS/ % Change in EBIT
= % change in EPS / % Change sales
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Contribution / EBT (!R) FL*!L
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ë The combined leverage can work in both directions. It is favorable if sales increase
and unfavourable when sales decrease.

ë 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.

ë 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. !perating leverage also acts as a
check on financial leverage.
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ë 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 (R! A or R!I).

ë EPS, R!E and R!I are the important figures for analysing the impact of

financial leveraged

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ë Find out the 50 SE listed Companies and calculate Financial, combined and
!peration leverage and Interprate the same.

ë www.nseindia.com