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Capital Structure Theories^295

Company XYZ enjoys a tax shield of Rs 0.6mn. Assuming that the above capital structure
remains unchanged for 3 years, then at the current level of profitability, after 3 years
company ABC would have paid Rs 6mn as interest whereas the company XYZ would
have paid Rs 4.2 mn thus saving Rs 1.8mn in taxes in 3 years.

However, a major drawback with debt is that it entails a liability for the company for a
particular period of time and thus might act as a drawback in improving profitability
during the lean phase of business. However, equity doesn't have the above mentioned
disadvantage. During stable market conditions, debt is perhaps the cheapest mode of
raising capital from external sources. But in volatile market conditions, equity is perhaps
the safest mode.

Normally a company wishes to raise capital by way of both equity and debt because of
the several constraints mentioned below. To make the task easier in deciding what to
raise and how much to raise, we use a technique known as EBIT-EPS analysis. This
analysis helps us to understand how sensitive is EPS to changes in EBIT under different
financing alternatives. It is also possible to calculate the break even EBIT level (for
two alternative financing plans), i.e., the level of EBIT for which the EPS is the same.
The EBIT indifference point between the two alternative plans can be obtained
mathematically by solving the following equation for EBIT:

(EBIT - I 1 ) ( 1 - t) = (EBIT - I 2 ) ( 1 - t)

-------------------------- -------------------------

n 1 n 2

Where,

EBIT = indifference point between the two alternative financing plans

I 1 , I 2 = interest expenses before taxes under financing plans 1 and 2

t = income tax rate

n 1 , n 2 = number of equity shares outstanding after adopting financing

plans 1 and 2.

Below this level of EBIT it would be useful to raise money from equity only and above
this level of EBIT, raising money from debt would be a suitable alternative.

Assessment of Debt Capacity & Planning

The Capital Structure

At the optimum capital structure the value of an equity share is the maximum and the
average cost of capital is the minimum. A capital structure is considered to be appropriate
if the following conditions are met:

1. Profitability: The capital structure should result in maximum profitability.