Planning the Capital Structure. Planning an appropriate Capital Structure for a company depends upon various parameters and circumstances specific to that company. Deciding on a suitable mix of debt, equity, and other components of ‘Capital Structure’ requires a careful study of those parameters and circumstances.
Computation of Working Capital Requirements
This assumes more significance in the context of promoting a company, as the ‘Capital Structure’ designed initially will have a far-reaching impact on the performance of new the company. Changes in the initial ‘Capital Structure’ are effected from time to time during investment decisions or depending upon the need of the hour.
Such changes are required and also necessary from the point of view of the eventual survival of the business. An optimal ‘Capital Structure of a company ensures an ideal Liability Side’ of its balance sheet, which is a combination of various categories of finance raised from internal (equity capital including preference capital) and external (debt finance and borrowings) sources.
Thus, the impact of an optimal ‘Capital Structure’ is strong for the Liability Side of the company’s balance sheet.
Various techniques are applied to plan an optimal ‘Capital Structure’, which are discussed in the following paragraphs:
Planning the Capital Structure
1) EBIT-EPS Analysis:
This is the most commonly used methodology for drawing an ‘Optimal Capital Structure. EBIT/EPS analysis entails the comparative study of various choices available under hypothetical figures of variable EBIT/EPS.
A ‘Capital Structure’, for a specific level of EBIT can ensure the highest EPS. This would be the best choice among all combinations of sources. The next best alternative would be the one, which can Tenure the highest Market Price per Share (MPS), which is the intrinsic value of a share. MPS may be calculated by using the following formula: (MPS) = EPS x P/E ratio.
2) Cost of Capital:
The cost of capital is an important aspect to be kept in mind while designing an optimal ‘Capital Structure’ for a company. Earnings of a business organization must be at least equal to, if not more than, the cost of capital in order to survive. Further growth of the business is possible only if the earnings are more than the cost of capital. Therefore, the decision-making authority of a company, while drafting its ‘Capital Structure needs to take into consideration the cost of capital besides the risk factors.
3) Cashflow Analysis:
‘Capital Structure of a company is a combination of various components of (sources of funds). Debt funds are such components and their servicing (payment of principal on maturity and interest accrued thereon from time to time) is of paramount importance. A company’s strength to serve its debt instruments depends upon the cash inflow generated by it Cashflow analysis is basically an indicator of a company’s means to serve its debt liabilities; it is also an indicator of risk arising out of cash insolvency.
As a first step in undertaking the cash flow analysis, proforma cash flow statements are prepared to assess the financial position of a company. The projected cashflows may be grouped under three categories:
The cashflows generated out of the basic or core operational activity of a company are a vital indicator of the level of cash generated through the operations of the company, and also whether the same is enough to:
a) Sustain the company’s operational efficiency.
b) Pay dividends.
c) Serve debt instruments raised by it from time to time.
d) Repay the funds borrowed by it from institutional lenders, and
e) Invest in new projects,
without resorting to external sources of funds. Data gathered with regard to the cash generated from the core activity of the company in the past, along with certain other inputs, is helpful in projecting future operating cashflows.
ii) Investing Activities:
The cash flows generated from the investments made by the company need to be indicated separately. This category of cash flow is significant as it reflects the expenses incurred in connection with the investing activity meant for the generation of future income and inflows.
iii) Financing Activities:
The cash flows generated from the company’s financing activities also need to be indicated separately. Such disclosure gains importance in view of its usefulness in assessing the claims of the fund providers (both owned capital and borrowed capital) to the company, on future cashflows.
The cashflow analysis is one of the most important inputs for planning an optimal ‘Capital Structure of a company. A company, which is healthy from a profitability angle, but not using the tool of cashflow analysis’, may be exposed to the risk of default and ultimately face trouble.
4) Leverage Analysis:
Under this type of analysis, the relationship between two variables is more significant rather than the measurement of the variable themselves. It may be expressed as follows:
Leverage = % Change in dependent variable / Change in independent variable.
In the business, leverage emerges from the fixed cost. Leverage, which is the outcome of a company’s fixed operating costs, is termed ‘Operating Leverage’, while leverage, which is the outcome of a company’s fixed financing costs, is termed ‘Financial Leverage’. A combination of both (financing and operating leverage) is termed ‘Composite Leverage’.