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What is optimal capital structure? How to calculate it?


Optimal Capital Structure: It is decided on the basis of market level not on the basis of company’s earnings. If market increases then company have to increase its debt capital in capital structure otherwise reduces it to achieve capital structure objectives i.e.
·         Minimizing the cost of capital.
·         Increases the Earnings Per Share (EPS).

Indifference Point: It is a level of Earnings Before Interest Tax (EBIT) where given capital structures provide same Earnings Per Share (EPS).
Formula:

(EBIT-Interest) (1-Tax)/ Number of equity 1 = (EBIT-Interest) (1-Tax)/ Number of equity2

Example: A company X has outstanding debt of Rs.30, 00,000 @ 10% and equity of Rs.10, 00,000 of Rs.10 each. Company wants Rs.20, 00,000 to expand its business to fulfill the market requirement. Find out the optimal capital structure with the help of following information:
·         EBIT = Rs.50,00,000
·         Tax = 40%
·         Further capital raise through: Debt 8% or equity.

Solution:

Particulars
Case 1 (Fully Debt)
Case 2 (Fully Equity)
EBIT
50,00,000
50,00,000
Less: interest
3,00,000
3,00,000

47,00,000
47,00,000
Less: Interest
1,60,000
----
EBT
45,40,000
47,00,000
Less: tax
18,16,000
18,80,000
Earnings available for equity holders
27,24,000
28,20,000
Number of equity
4,00,000
6,00,000
EPS
6.81
4.7

Interpretation: In Case 1 further capital raise through fully debt gives 6.81 EPS which is more than Case 2 where capital raise through fully equity. So, optimal Capital structure is 5:1 i.e. debt: equity.
Example: Company A suffer a loss and it have outstanding debt of Rs.10,00,000 and equity of Rs.6,00,000.To handle this situation company reduces its capital structure. Find out new capital structure. Other information is as follows:
·         EBIT = Rs.8,00,000
·         Tax = 30%
·         Debt reduces up to Rs.7,00,000

Solution:

Particulars
New Capital Structure
Old Capital structure
EBIT
8,00,000
8,00,000
Less: Interest
70,000
1,00,000
EBT
7,30,000
7,00,000
Less: tax
2,19,000
2,10,000
Earnings available for shareholders
5,11,000
4,90,000
Number of shares
60,000
60,000
EPS
8.51
8.16

The new capital structure is Debt: Equity: 7:6.

Example: Company Y has three options to raise further capital of Rs.60, 00,000:
·         Case 1: Fully equity of Rs.100 each.
·         Case 2: Fully debt @ 10%
·         Case 3: 3:2:1 ratios of debt @10%, equity Rs.100 each and preference share @ 8%.
Further information is:
·         EBIT = Rs. 12, 00,000
·         Tax: 40%
·         Outstanding equity of Rs. 20,00,000 of Rs.100 each
Find out which option gives highest EPS and also the next best option of capital structure with the help of indifferent point.

Solution:

Particulars
Case 1
Case 2
Case 3
EBIT
12,00,000
12,00,000
12,00,000
Less: interest
------
6,00,000
2,00,000
EBT
12,00,000
6,00,000
10,00,000
Less: tax
4,80,000
2,40,000
4,00,000
Profit available for preference shareholders
7,20,000
3,60,000
6,00,000
Less: Preference dividend
------
-------
80,000
Profit available for shareholders
7,20,000
3,60,000
5,20,000
Number of shares
80,000
20,000
40,000
EPS
9
18
13

Indifference Point of case 2 and case 3:

(EBIT-Interest) (1-Tax)/ Number of equity 1 = (EBIT-Interest) (1-Tax) –Dividend / Number of equity2
=(X – 6, 00,000) (1-0.40) / 20,000 = (X-2, 00,000) (1-0.40) -80,000 / 40,000
= (X – 6, 00,000) (0.60) / 20,000 = (X-2, 00,000) (0.60) -80,000 / 40,000
= 0.6X- 3, 60,000 / 1 = 0.6X- 1, 20,000 – 80,000 / 2
= 1.2X- 7, 20,000 = 0.6X- 1, 20,000 – 80,000
= 1.2X- 0.6X = -1, 20,000 + 6, 40,000
= 0.6X = 5, 20,000
=X = 8, 66,666.66

Particulars
Case 2
Case 3
EBIT
8,66,666.66
8,66,666.66
Less: interest
6,00,000
2,00,000
EBT
2,66,666.66
6,66,666.66
Less: tax
1,06,666.66
2,66,666.66
Profit available for preference shareholders
1,60,000
4,00,000
Less: Preference dividend
-------
80,000
Profit available for shareholders
1,60,000
3,20,000
Number of shares
20,000
40,000
EPS
8
8

Interpretation: Case 2 gives the highest EPS in comparison of Case 1 and 3. The next best option is Case 3 and if EBIT is Rs.8, 66,666.66 then the case2 and 3 give same EPS of 8.

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