Capital structure

The term capital structure is used to represent the proportionate relationship

between debt preference and equity shares on a firms balance sheet

EBIT-EPS approach

• The EBIT-EPS approach is one method available to managers to guide them in making decisions about capital structure

• This approach helpful to analyze the impact of debt on earning per share

Drawbacks

• The EBIT-EPS approach places heavy emphasis on maximizing earnings per share rather than controlling costs and limiting risk

Calculation of EBIT

particulars amountsales xxx

variable cost xxcontribution xxxx

fixed cost xx

EBIT(earning before interest and taxes) xxxx

Particular AmountEBIT Xxxx(-) interest Xx= EBT Xxxx(-) Tax Xx= Earning for ESH XxxxDivided by no. of E.S

Xxx

EPS (Earning Per Share)

xxxx

Calculation of EPS

Q: The present capital structure of Gupta Co. ltd. is:4000, 5% Debentures of Rs 100 each Rs 4,00,0002000, 8% P. Shares of Rs 100 each Rs 2,00,0004000, Equity shares of Rs 100 each Rs 4,00,000

Rs 10,00,00010,00,000The present earning of the company before interest & taxes are 10% of the invested capital every year. The company is in need of Rs 2,00,000 for purchasing a new equipment and it is estimated that additional investment will also produce 10% earning before interest & taxes every year.The company has asked your advice as to whether the requisite amount be obtained in the form of 5% Debenture or 8% P. SharesOr equity shares of Rs 100 each to be issued at par. Examine the problem in all its bearing and advice firm if the Corporate tax rate is 50%.

Example

ParticularsPresent

iDebenture

iiP. Share

iiiEq. Share

EBIT(-)Interest

1,00,00020,000

1,20,00030,000

1,20,00020,000

1,20,00020,000

EBT(-)Tax 50%

80,00040,000

90,00045,000

1,00,00050,000

1,00,00050,000

EAT(-)P. Dividend

40,00016,000

45,00016,000

50,00032,000

50,00016,000

ESH(÷) No. of Equity Shares

24,0004,000

29,0004,000

18,0004,000

34,0006,000

EPSChange in EPS

Rs 6.00-

Rs 7.25+1.25

Rs 4.50-1.50

Rs 5.67-0.33

Tabulated structure

BREAKEVEN EBITEPS

EBIT$1m $2m $3m $4m

Debt + Equityalternative

EquityAlternative

0

3

2

1

Indifference point

Equity Advantages

Debt Advantages

Conclusion

• If expected EBIT > EBIT at indifference point debt financing is beneficial

• If expected EBIT < EBIT at indifference point equity financing is beneficial

Debt Financing

Equity Financing

Residual dividend

• The dividend payments are made from the equity that remains after all the project capital needs are met. This equity is also known as residual equity

•  If a certain amount of money is left after all forms of business expenses then the corporate houses distribute that money among its shareholders as dividends.

• Companies that follow a residual dividend policy only when other satisfactory opportunities and sources of investment of funds are not available.

Stable dividend policy

It is the policy in which dividend given is fixed ,stable or consistently given at a regular interval of time.

Benefits

1. Confidence Among Shareholders.

2. Income Conscious Investors.

3. Stability in Market Price of Shares.

4. Encouragement to Institutional Investors.

Dividend policy VS Bonus shares

• The policy a company uses to decide how much it will pay out to shareholders in dividends

• It does not increase the number of share with the share holder

• Bonus shares are shares given to existing stockholders in proportion to the number of shares they hold.

• The total number of share gets increased.

Dividend Policy Bonus shares

• The policy a company uses to decide how much it will pay out to shareholders in dividends.

• It means repurchasing its own share in the market out of the profit generated

Buy back of shareDividend Policy

surplus earnings are distributed to share holders in the form of cash dividends or to repurchase the company's stock

Dividend Policy V/S buy back of share

Bonus shares are shares given to existing stockholders in

proportion to the number of shares they hold.

the EPS would reduce as the equity capital has gone up

Bonus shares are issued from the free reserves of the

company

Stock splits are mainly carried out with the intention of

increasing liquidity

new investors might like to buy the stock as it is available at a

lower price

stock-split is a division of a share into shares with lower face

value.

Bonus shares V/S stock split