Determinants of Capital Structure

Name: Sneha LotlikarRoll 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

If the Shareholders' Base increases - > Dilution of Control

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.

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