Capital structure

The essentials

Capital structure refers to the mix of owners' funds (equity share capital and retained earnings) and borrowed funds (debentures and loans) used by a business. The proportion of debt to equity is called financial leverage. A good capital structure balances cost and risk to maximise shareholders' wealth.

Key points

• Trading on equity: using fixed-cost debt to increase the earnings per share (EPS) of equity shareholders. It works only when the return on investment (ROI) is higher than the rate of interest on debt. If ROI is lower than the cost of debt, debt reduces EPS.
• Factors affecting capital structure: cash flow position (ability to pay interest and repay debt), interest coverage ratio (EBIT ÷ interest; higher is safer), debt service coverage ratio, return on investment, cost of debt, tax rate (higher tax makes debt cheaper after tax), cost of equity, floatation costs, risk consideration, flexibility (keeping some borrowing capacity unused), control, regulatory framework, stock market conditions, and the capital structure of other companies in the industry.
• Example: a firm with total funds of ₹10 lakh earns EBIT of ₹2 lakh (ROI 20%). With all equity (1 lakh shares of ₹10) and a 30% tax rate, EPS = ₹1.40. If it uses ₹5 lakh of 10% debt and 50,000 shares, EPS = (2,00,000 − 50,000) × 0.7 ÷ 50,000 = ₹2.10.

Exam tips

• Compare ROI with the interest rate first to decide whether trading on equity will help.
• A higher interest coverage ratio means the firm can safely take more debt.

Common mistakes

• Thinking more debt always increases EPS. It does so only when ROI exceeds the cost of debt.
• Forgetting to deduct tax when calculating EPS.