LOTERIA, Mikaela Joyce C.

BSA601- FINMAN2

1. What is Capital Structure?

The capital structure is the particular combination of debt and equity used by a company to finance its
overall operations and growth. Debt comes in the form of bond issues or loans, while equity may come in
the form of common stock, preferred stock, or retained earnings.

2. What is the financial manager’s objective in making financing decisions?

The financial manager’s objective in making capital structure decisions is to find the financial mix that
maximizes the value of the firm. The structure is called optimal caital structure.

3. What are the similarities and differences between the traditional, Modigliani and Miller, and
contemorary approaches to capital structure?

 Under idealized conditions with no income taxes, the traditional approach to capital
structure suggests that there is an optimal capital structure which simultaneously maximizes the
firm’s market value and minimizes its weighted average cost of capital.
 Under idealized conditions with no income taxes, the Modigliani and Miller model implies that
the total market value and cost of capital are independent of a firm’s capital structure.
 Under idealized conditions with corporate income taxes, the Modigliani and Miller model
concludes that leverage affects value, and that firms should be financed with virtually all debt.
 Under relaxed assumptions, the contemporary approach suggests that there is an optimal range for
the capital structure of the firm. If the firm finances outside this range, the value of the firm will
decline.

4. How a firm might go about determining its optimal or target capital structure?

The use of both analytical techniques and procedures of the management determines the optimal capital
structure of the firm. Decisions and professional judgment of management involves in determining the
capital structure, which consists of trade-off among benefits and costs.

5. What is EBIT – EPPS Analysis?

A firm can analyze its capital structure by performing an EBIT – EPS analysis. EBIT-EPS analysis is a
technique used to determine the optimal capital structure in which the value of earnings per share (EPS)
has the highest amount for a given amount of earnings before interest and taxes (EBIT). In other words,
the objective of EBIT-EPS analysis is to determine the effect of using different sources of financing on
EPS.
LOTERIA, Mikaela Joyce C.
BSA601- FINMAN2

6. How to find an EBIT-EPS indifference point?

The indifference point is the EBIT level at which EPS is equal underalternate financing plans. This point
may be found either graphically ormathematically.

7. What are the major criticisms of EBIT – EPS analysis?

Risk is not taken into account - EBIT-EPS analysis does not take into account the risks associated with
debt financing. In other words, a higher EPS associated with using financial leverage implies a higher risk
that has to be taken into account by management.

Complexity - The more alternative financing plans are considered, the higher the complexity of the
calculations.

Limitations - The technique does not account for limitations in raising various sources of financing.

8. What are the factors other than wealth considerations that may influence capital structure
decisions?

Capital structure decisions are tempered by such considerations as cashflow, market conditions,
profitability and stability, control, managementpreferences, financial flexibility, and business risk.

OTHERS:

1. Cash Flow Position:

The decision related to composition of capital structure also depends upon the ability of business to
generate enough cash flow.

The company is under legal obligation to pay a fixed rate of interest to debenture holders, dividend to
preference shares and principal and interest amount for loan. Sometimes company makes sufficient profit
but it is not able to generate cash inflow for making payments.

The expected cash flow must match with the obligation of making payments because if company fails to
make fixed payment it may face insolvency. Before including the debt in capital structure company must
analyse properly the liquidity of its working capital.

2. Interest Coverage Ratio (ICR):

LOTERIA, Mikaela Joyce C.
BSA601- FINMAN2

It refers to number of time companies earnings before interest and taxes (EBIT) cover the interest
payment obligation.

ICR= EBIT/ Interest

High ICR means companies can have more of borrowed fund securities whereas lower ICR means less
borrowed fund securities.

3. Debt Service Coverage Ratio (DSCR)

If DSCR is high then company can have more debt in capital structure as high DSCR indicates ability of
company to repay its debt but if DSCR is less then company must avoid debt and depend upon equity
capital only.

4. Return on Investment:

Return on investment is another crucial factor which helps in deciding the capital structure. If return on
investment is more than rate of interest then company must prefer debt in its capital structure whereas if
return on investment is less than rate of interest to be paid on debt, then company should avoid debt and
rely on equity capital. This point is explained earlier also in financial gearing by giving examples.

5. Cost of Debt:

If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as compared to
equity.

6. Tax Rate:

High tax rate makes debt cheaper as interest paid to debt security holders is subtracted from income
before calculating tax whereas companies have to pay tax on dividend paid to shareholders. So high end
tax rate means prefer debt whereas at low tax rate we can prefer equity in capital structure.

7. Cost of Equity:

Another factor which helps in deciding capital structure is cost of equity. Owners or equity shareholders
expect a return on their investment i.e., earning per share. As far as debt is increasing earnings per share
LOTERIA, Mikaela Joyce C.
BSA601- FINMAN2

(EPS), then we can include it in capital structure but when EPS starts decreasing with inclusion of debt
then we must depend upon equity share capital only.