Capital Structure Theories^309
Cash Flow Analysis Versus Debt-Equity Ratio
The cash flow analysis clearly reveals that a higher debt-equity ratio is not risky if the
company has the ability of generating substantial cash inflows in the future to meet its
fixed financial obligations. Financial risk in this sense is indicated by the company's
cash-flow ability, not by the debt-equity ratio. To quote Van Home;
...the analysis of debt-to-equity ratios alone can be deceiving, and analysis of the
magnitude and stability of cash-flows relative to fixed charges is extremely important in
determining the appropriate capital structure for the firm. To the extent that creditors
and investors analyse a firm's cash-flow ability to service debt, and management's risk
preferences correspond to those of investors, capital structure decisions made in this
basis should tend to maximise share price.
The cash flow analysis does have its limitations It is difficult to predict all possible
factors which May influence the firm's cash flows. Therefore, it is not a fool-proof
technique to determine the firm's debt policy.
EBIT-EPS Analysis
The EBIT-EPS analysis, as a method to study the effect of leverage, essentially involves
the comparison of alternative methods of financing under various assumptions of EBIT.
A firm has the choice to raise funds for financing its investment proposals from different
sources in different proportions. For instance, it can (i) exclusively use equity capital (ii)
exclusively use debt,
(iii) exclusively use preference capital, (iv) use a combination of (i) and (ii) in different
proportions; (v) a combination of (i), Oil and (iii) in different proportions, (vi) a combination
of (i) and (iii) in different proportions, and so on. The choice of the combination of the
various sources would he one which, given the level of earnings before interest and
taxes, would ensure the largest EPS. Consider Example 2.
Example 2:
Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting
to Re 10,00,000. The firm now wishes to raise additional Rs 10,00,000 for expansion.
The firm has four alternative financial plans:
(A) It con raise the entire amount in the form of equity capital.
(B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures.
(C) It can raise the entire amount as 6% debentures.
(D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference
capital.