Unit 3: Financial Decision
Capital Structure
Capital structure refers to the mix of debt and equity a company uses to finance its operations and growth.
Components:
- Equity: Owner’s funds (e.g., common shares, retained earnings)
- Debt: Borrowed funds (e.g., loans, bonds)
Objective of Capital Structure:
- Maximize firm value
- Minimize cost of capital (WACC)
Relevance Theory of Capital Structure
Proposed by: David Durand
Belief: Capital structure affects the value of the firm.
Theories under Relevance
1. Net Income (NI) Approach
- Assumption: Cost of debt is less than equity.
- More debt → Lower WACC → Higher firm value.
- Implication: Capital structure is important.
2. Traditional Approach
- Optimal capital structure exists.
- Initially, adding debt decreases WACC → increases value.
- Too much debt → increases risk → raises WACC.
- Implication: Balance is key.
❌ Irrelevance Theory of Capital Structure
Proposed by: Modigliani and Miller (MM Theory) (Without taxes)
Belief: Capital structure has no impact on firm value.
Assumptions:
- No taxes
- No bankruptcy costs
- Perfect capital markets
Key Points:
- Value of firm = Based on its earnings, not capital structure.
- Investors can create their own leverage.
MM Theory (With Taxes)
- Interest on debt is tax-deductible → Encourages use of debt → Value of firm increases.
Summary Table
Leverage Analysis
Leverage refers to how a company uses fixed costs (either operating or financial) to increase the potential returns to shareholders.
Types of Leverage
1. Operating Leverage
Use of fixed operating costs (e.g., rent, salaries) to magnify the effect of changes in sales on EBIT (Earnings Before Interest and Taxes).
Formula: 👉 DOL (Degree of Operating Leverage) =
Implication:
- High DOL = More sensitive EBIT to sales changes.
- Risk: High operating leverage is risky during sales decline but profitable during a rise.
2. Financial Leverage
Use of fixed financial costs (e.g., interest on debt) to magnify the effect of changes in EBIT on EPS (Earnings Per Share).
Formula: 👉 DFL (Degree of Financial Leverage) =
Implication:
- High DFL = More sensitive EPS to changes in EBIT.
- Risk: High financial leverage increases financial risk (risk of insolvency due to interest burden).
3. Combined Leverage
Combination of both operating and financial leverage. It shows the impact of change in sales on EPS.
Formula: 👉 DCL (Degree of Combined Leverage) =
Implication
- High DCL = Very sensitive EPS to sales changes.
- Risk: High combined leverage means high total risk (operational + financial).
📊 Summary Table
EBIT-EPS Analysis
EBIT-EPS analysis helps in choosing the best financing option (like equity, debt, or preference shares) by analyzing how each option affects Earnings Per Share (EPS) at different levels of EBIT (Earnings Before Interest and Taxes).
🎯 Objective:
- To determine which financing plan gives the highest EPS at a given EBIT level.
📊 How It Works:
- You calculate EPS under different financing plans (e.g., all equity, equity + debt, equity + preference shares).
- Compare the EPS under each plan for various EBIT levels.
Point of Indifference
The EBIT level at which EPS is the same under two or more financing alternatives.
👉 Formula to find Indifference Point between two financing options:
Let:
- Plan A: All equity
- Plan B: Equity + Debt
- Then, the indifference point is where:
Assume:
- EBIT = Earnings before interest & tax
- I = Interest on debt
- T = Tax rate
- E = No. of equity shares under each plan
Solve for EBIT → That’s your point of indifference.
💡 Implications of EBIT-EPS Analysis
