1) State the different types of Capital Structure?

 Horizontal Capital Structure: The firm has no debt in capital structure. Funds for
expansion are sourced through equity or retained earnings only. Absence of debt
results in lack of financial leverage.

 Vertical Capital Structure: The base of the structure is formed by a small amount
of equity share capital that serves as a foundation on which the super structure
of preference share capital and debt is built. The high component of debt in the
capital structure increases the financial risk of the firm and renders the structure
unstable.

 Pyramid Shaped Capital Structure: A pyramid shaped capital structure has a large
proportion consisting of equity capital and retained earnings. This structure is
indicative of risk averse conservative firms.

 Inverted Pyramid Shaped Capital Structure: Such a capital structure has a small
component of equity capital, reasonable level of retained earnings but an ever-
increasing component of debt. Such a capital structure is highly vulnerable to
collapse.

2) What is the significance of a firm’s Capital Structure?

 It reflects the Firm’s Strategy: In case the firm wants to grow at a faster pace,
it would be required to incorporate debt in its capital structure to a greater
extent. The strategy includes the pace of growth of the firm.

 It is an Indicator of the Risk Profile of the firm: If the debt component in the
capital structure is predominant, the fixed interest cost of the firm increases
thereby increasing its risk. If the firm has no long-term debt in its capital
structure, it means that either it is risk averse.

 Acts as a tax management tool: The interest on borrowings is tax deductible, a

firm having healthy growth in operating profits would find it worthwhile to
incorporate debt in the capital structure in a greater measure.

 Helps to brighten the image of the firm: A firm can build on the retained earnings
component of the capital structure by issuing equity capital at a premium to a
spread-out base of small investors that improves the image in the eyes of investors
and reduces the chances of hostile takeover.

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 3) What are the attributes of a well-planned capital structure?

 Return: The capital structure of the company should be most advantageous to

generate maximum returns without adding additional cost.

 Risk: Debt should be used to the point it does not add significant risk. Use of
excessive debt should not threaten the solvency of company.

 Flexibility: It should be possible for a company to adapt its capital structure with
a minimum cost & provide funds whenever needed to finance its profitable
activities.

 Capacity: The capital structure should be determined within the debt capacity of
the company based upon the company’s ability to generate future cash flows to
pay fixed charges and principal sum.

 Control: The capital structure should involve minimum risk of loss of control of the
company.

4) While designing a capital structure; what points need to be kept in view?

 Design should be Functional: The design should create synergy with long term
strategy of the firm & help facilitate day to day working of the firm.

 Design should be Flexible: The capital structure should facilitate temporary

expansion or contraction of each component.

 Design should be conforming statutory guidelines: The limits imposed by lenders

regarding the minimum level of owners’ equity required in the firm should be
complied with & be in conformity with statutory guidelines.

5) State the chief factors affecting the choice of capital structure?

 Cash Flow Position: While making a choice of the capital structure the future cash
flow position should be considered. Like huge cash flow for refund of capital &
payment of interest is required in case of debt financing.

 Interest Coverage Ratio: With the help of this ratio an effort is made to find out
how many times the EBIT is available to the payment of interest.

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  Return on Investment: The greater return on investment of a company increases
its capacity to utilise more debt capital.

 Cost of Debt: In case the rate of interest on the debt capital is less, more debt
capital can be utilised and vice versa.

 Tax Rate: Higher the rate of tax; the cost of debt decreases.

 Cost of Equity Capital: If the debt capital is utilised more, it will increase the cost
of the equity capital. It adversely affects the market value of the shares & efforts
should be made to avoid it.

 Floatation Costs: Floatation costs are those expenses incurred while issuing
securities such as underwriter’s commission, brokerage, stationary expenses, etc.
Such costs on issuing debt capital are less than share capital.

 Risk Consideration: Operating Risk or business risk is created because of

operating fixed cost such as rent, depreciation, etc. and financial risk is created
due to financial fixed costs such as interest & preference dividend.

 Flexibility: Flexibility means that, if needed, the amount of capital in the business
could be increased or decreased easily. Thus, from the viewpoint of flexibility to
issue debt capital and preference share capital is the best as compared to
repayment of equity share capital.

 Control: Efforts should be made to ensure that the control of the existing
shareholders is not adversely affected. Funds raised through issue of equity
shares dilutes control among new shareholders.

 Regulatory Framework: Government regulations influence the capital structure of

the firm like maintenance of given debt-equity ratio while raising funds. (e.g. SEBI
guidelines)

 Stock Market Conditions: Refer to upward or downward trends in capital market.

When the market is dull, investors are mostly afraid of investing in the share
capital due to high risk & vice versa.

 Capital Structure of Other Companies: At the time of raising funds a company must
take into consideration debt-equity ratio prevalent in the related industry to
which the company is related.

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 6) Explain EBIDTA analysis and state it’s limitations & advantages EBIDTA.

 EBITDA is used to analyze a company’s operating profitability before non-

operating expenses and non-cash charges.
 EBIDTA enables analysts to exclude the impacts of non-operating activities and
focus on the outcome of operating decisions.
 Non-operating activities include interest expenses, tax rates, and large non-cash
items such as depreciation and amortization.

 Limitations of EBIDTA: Factoring out interest, taxes, depreciation and

amortization can make even completely unprofitable firms appear attractive as
manipulation of EBIDTA numbers is easy.

 Advantages of EBIDTA:
a) EBITDA can be used as a shortcut to estimate the cash flow available to pay
debt on long-term assets, such as equipment and other items.
b) EBITDA can also be used to compare companies against each other and against
industry averages.

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