Capital Structure Theories^305
The valuation framework makes it clear that excessive debt will reduce the share:
price (or increase the cost of equity) and thereby lower the overall return to shareholders,
despite the increase in EPS. The return of shareholders is made of dividends and
appreciation in share prices, not of EPS. Thus, the impact of debt - equity ratio should
be evaluated in terms of value, rather than EPS.
The difficulty with the valuation framework is that managers find it difficult to put into
practice. It is not possible for them to quantify all variables. Also, the operations of the
financial markets are so complicated that it is not easy to understand them. But this
kind of analysis does provide insights and qualitative guidance to the decision maker.
The trade-off between cost of capital and EPS set the maximum limit to the use of
debt. However, other factors should also be evaluated to determine the appropriate
capital structure for a company.
Cash Flow Approach
One of the features of a sound capital structure is conservatism. Conservatism does
not mean employing no debt or small amount of debt. Conservatism is related to the
fixed charges created by the use of debt or preference capital in the capital structure
and the firm's ability to generate cash to meet these fixed charges. In practice, the
question of the optimum (appropriate) debt-equity mix boils down to the firm's ability to
service debt without any threat of insolvency and operating inflexibility. A firm is
considered prudently financed if it is able to service its Fixed charges undet any reasonably
predictable adverse conditions.
The fixed charges of a company include payment of interest, preference dividends and
principal, and they depend on both the amount of loan securities and the terms of
payment. The amount of fixed charges will be high if the company employs a large
amount of debt or preference capital with short-term maturity. Whenever a company
thinks of raising additional debt, it should analyse its expected future cash flows to meet
the fixed charges. It is mandatory to pay interest and return the principal amount of
debt. If a company is not able to generate enough cash to meet its fixed obligation, it
may have to face financial insolvency. The companies expecting larger and stable cash
inflows in the future can employ a large amount of debt in their capital structure. It is
quite risky to employ fixed charge sources of finance by those companies whose cash
inflows are unstable and unpredictable. It is possible for a high growth, profitable company
to suffer from cash shortage if its liquidity (working capital) management is poor. We
have examples of companies like BHEL, NTPC etc., whose debtors are very sticky
and they continuously face liquidity problem in spite of being profitable. Servicing debt
is very burdensome for them.
One important ratio which should be examined at the time of planning the capital structure