Capital Structure

• Capital structure is the mix between owners' funds and borrowed funds.
• Owners' funds include equity, preference share capital, reserves and retained earnings.
• Borrowed funds include loans, debentures, public deposits, etc.
• The mix is expressed through the debt-equity ratio and the proportion of debt in total capital.

\[\frac{\mathrm{Debt}}{\mathrm{Equity}}\]  (D/E)

\[\frac{\mathrm{Debt}}{\mathrm{Debt}+\mathrm{Equity}}\]  \[\left(\frac{D}{D+E}\right)\]

\[\frac{\mathrm{EBIT}}{\text{Total Investment}}\times100\]

Debt

• Cheaper than equity because interest is tax-deductible.
• Interest and repayment of principal are compulsory.
• Increases financial risk.

Equity

• Costlier than debt.
• Dividend is paid out of after-tax profits.
• No compulsory payment; therefore, riskless for the business.

• Financial risk is the chance that a firm would fail to meet its payment obligations.
• Higher use of debt increases fixed financial charges and financial risk.

• Financial leverage is the proportion of debt in the capital structure.
• As financial leverage increases:
  • Cost of funds declines due to increased use of cheaper debt.
  • Financial risk increases.
• An optimal capital structure is the debt-equity mix that maximizes shareholders' wealth.

• Trading on Equity refers to the increase in profit earned by equity shareholders due to the presence of fixed financial charges like interest.
• It is advisable only when RoI > Cost of Debt.

Given

• Total Funds = ₹30 lakh
• Interest Rate = 10% p.a.
• Tax Rate = 30%
• EBIT = ₹4 lakh

Analysis

• RoI \[=\frac{4}{30}\times100=13.33\%\]
• Cost of Debt = 10%

Since RoI (13.33%) > Cost of Debt (10%), the company earns more on borrowed funds than it pays as interest.

Result

• EPS increases as debt increases.
• This is Favourable Financial Leverage.
• Trading on Equity is advisable.

All details remain the same as Company X except:

• EBIT = ₹2 lakh

Analysis

• RoI \[=\frac{2}{30}\times100=6.67\%\]
• Cost of Debt = 10%

Since RoI (6.67%) < Cost of Debt (10%), the company earns less on borrowed funds than it pays as interest.

Result

• EPS decreases as debt increases.
• This is Unfavourable Financial Leverage.
• Trading on Equity is inadvisable.

• Capital structure = Mix of owners' funds and borrowed funds.
• Debt is cheaper but riskier than equity.
• Financial risk increases with higher debt.
• Financial leverage is measured by D/E or D/(D+E).
• Optimal capital structure maximizes shareholders' wealth.
• Favourable Financial Leverage: RoI > Cost of Debt → EPS increases.
• Unfavourable Financial Leverage: RoI < Cost of Debt → EPS decreases.
• Trading on Equity should be used only when RoI exceeds the Cost of Debt.