Capital Structure refers to the way a corporation finances its assets through some

combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources. Capital structure of a Company refers to the composition or make up of its capitalization and it includes all long-term capital resources, viz, loans, bonds, shares, and reserves Gerestenberg

Thus capital structure is made up of debt and equity securities and refers to permanent financing of a firm. A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of fundsss The capital structure of a company is the particular combination of debt, equity and other sources of finance that it uses to fund its long term financing. The key division in capital structure is between debt and equity. The proportion of debt funding is measured by gearing Optimal Capital Structure As already referred to companies want to be optimally structured i to capital. Neither over dependence on equity nor on debt capital is advised. Again extent of dependence on any type of capital is influenced by both firm lific and market-wide factors. Optimal capital structure as earlier referred to is one that: maximizes value of the firm, minimizes overall cost of capital, rigidity of capital structure, enhances control over affairs of the less, increases simplicity of capital structure, ensures enjoyment of tax , helps reaping financial leverage benefits to the maximum and so on. Optimum capital structure is a classical concept. Debt capital and capital are in fine balance here producing optimal results on value, cost, ige, and the like. As a firm uses debt upto a level its value increase. Beyond level debt capital proves costlier and value starts dropping downwards. The debt equity, point at which value is maximized, is called the optimal capital structure. Optimal capital structure varies with firms and with market factors. As market and firm specific factors keep changing, optimal capital structure also varies.

Businesses try to reach optimal capital structure. Do they reach is question mark. Mostly, they are about, but not at optimal capital structure.

Financial Structure
Framework of various types of financing employed by a firm to acquire and support resources necessary for its operations. Commonly, it comprises of stockholders' (shareholders') investments (equity capital), long-term loans (loan capital), short-term loans (such as overdraft), and short-term liabilities (such as trade credit) as reflected on the right-hand side of the firm's balance sheet. Capital structure, in comparison, does not include short-term liabilities. The right side of a firm's balance sheet, detailing how its assets are financed, including debt and equity issues.

Capital Structure Planning

The capital structure for a business should be planned. To plan capital structure, therefore, means determining the debt-equity proportion and mix of individual components of equity (paid equity and earned equity, that is ratio of paid up equity capital to retained earnings) and mix of debt capital types (bank loan, debentures, public deposits, etc.,) so that the firm is optimally capitalized. Optimum capital structure is one that maximizes value of business, minimizes overall cost of capital, that is flexible, simple and futuristic, that ensures adequate control on affairs of the business by the owners and so on. To reap the above benefits without accompanying costs, planning of capital structure is needed.

Capitalization
The debt and/or equity mix those funds a firm's assets. The amounts and types of long-term financing used by a firm. Types of financing include common stock, preferred stock, retained earnings, and long-term debt. A firm with capitalization including little or no long-term debt is considered to be financed very conservatively. Theories of Capital Structure The theories of capital structure analyses whether or not value of the firm is influenced by capital structure. There are several theories of capital structure. Net income, net operating income and Modigliani-Miller theories are some capital structure theories. The theories are based on the following general assumptions:

1. 2. 3. 4. 5. 6. 7. 8. 9.

Only two sources of capital, debt and equity, are used Debt capital is cheaper than equity capital Debt capital cost is fixed There is no corporate taxation There is perfect competition in capital market There is 100% dividend payout. The total assets do not change, there is no expansion The operating profit, ie., EBIT remains constant Business risk is constant over time and is independent of capital struct and financial risk. 10. There is perpetual life of the firm. Significance of Capital Structure Analysis In a world of corporate taxation, capital structure is analysis is relevant. It helps firms to have optimum capital structure. More the tax rate, more debt will help maximizing value of the business. Yet, there is a limit, beyond which debt capital induced leverage benefit may be eaten away by enhanced financial and business risk requiring the firm to pay more interest on debt as well as more reward to equity investors.

Leverage
Leverage means the fixed commitment of the organization. The fixed commitment of the organization can be classified into two different categories viz fixed cost of operations and fixed cost of servicing. The fixed cost of operations are pertaining to the investment decisions and the fixed cost of servicing with reference to the financing decision. Fixed cost of operations Investment decisions. Fixed cost of servicing Financing decisions. If Revenues are more than the Variable Cost and Fixed Cost, that is called favorable or otherwise unfavorable.

OPERATING LEVERAGE
Operating Leverage is connected with the acquisition of assets where as the financial Leverage is connected with the Financing of activities. Operating leverage: It is a relationship in between the Sales and Earnings before interest and taxes.

Financial leverage: It is a relationship in between the Earnings before interest and taxes and Earnings per share. Operating and Financial: In the Operating and Financial leverages, the EBIT is found as a common phenomenon. During the first part of the chapter, let us discuss about the operating leverage. It emerges only due to Fixed operating expenses. By and large, the expenses are classified into two categories viz Fixed and Variable in categories for the analysis of leverage. Operating Leverage is defined as the ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Described as % change in profits accompanying the % change in volume. "The firms' ability to use fixed operating costs to magnify the effects of changes in the sales on its earnings before interest and taxes". A firms sells products for Rs 100 per unit has variable operating costs of Rs. 50 per unit and fixed operating cost of Rs. 50,000 per year. Show the various levels of EBIT that would result from sale of i) 1000 units ii) 2000 units iii) 3000 units.

From the above illustration, it is obviously understood that from the two different cases. Case A illustrates that 50% increase in the volume of sales led to 100% increase in the volume of profit. Case B highlights that 50% reduction in the volume of sales led to 100% decrease in the volume of profit. It is clearly evidenced that % change in the volume of sales is less than the % change in the volume of profit. The next step is to define the Degree of Operating Leverage (DOL)

DOL is the measure reveals the extent or degree of operating leverage. When Operating leverage exists ?

Proportionate change in EBIT of a given change in sales is greater than the Proportionate in sales

By algebraically proven and the following formula has derived to determine the DOL Leverage Analysis through the alternate methodology

When there is no fixed cost in the cost of operations means that the firm does not have operating leverage in its operations. The operating leverage is related to the operating risk of the investments, which means that fixed cost of operations of the enterprise. It highlights that greater the fixed cost of operations means that higher the operating risk; which means that greater will be breakeven point and vice versa. The greater volume of fixed cost of operations are found to be more favorable only during the occasion of greater volume of earnings, unless otherwise the dominance of fixed cost of operations are found to be undesirable to magnify the volume of EBIT.

FINANCIAL LEVERAGE
The next leverage is Financial Leverage which arises due to servicing of financial resources. It results from the presence of fixed financial charges in the firms. The fixed financial charges are nothing but the preference dividend and interest on the fixed charge financial resources. Financial leverage, how the fixed charge financial resources influence the EBIT of the firm and finally provides earnings to the shareholders. It reveals the ability of the firm to make use of "fixed financial charges to magnify the effects of changes in EBIT on the earnings per share".

The other name of the financial leverage is Trading on Equity, which illustrates the relationship in between the application of the fixed charge of funds in the capital structure and Earning per share. It is the leverage analysis highlights the relationship in between the financing decision and investment decision. The fixed financial charge should pave way for the firm to not only to earn the greater EBIT but also to magnify the EPS of the shareholders. The financial manager of the hypothetical ltd expects that its earnings before interest and taxes (EBIT) in the current year would amount to Rs.10,000. The firm has 5 percent bonds aggregating Rs.40,000 while the 10 percent preference shares amount to Rs. 20,000 what should be the earnings per share (EPS)? Assuming the EBIT being i) Rs.6,000 Rs.14,000. How EPS is affected ? The firm tax bracket 35%. Ordinary number of shares 1,000

From the above illustration, 40% increase in the level of EBIT posed 81.25% increase in the EPS and vice versa. Financial leverage can be quantified through the Degree of Financial Leverage (DFL). The degree of financial leverage is defined as the ratio of % change in the EPS and % change in the EBIT, which always greater than 1. The degree of financial leverage is more than one due to presence of fixed charge of financial resources. This profound relationship is algebraically proven and illustrated that

The same example drawn for our better understanding by excluding the fixed charge of financial resources

It means that the higher Degree of financial leverage means that greater the financial risk of the firm and vice versa. The greater degree of financial leverage is favorable only during the greater volume of EBIT to meet the fixed charges unless otherwise, the firm is required to undergo for liquidation. The interest of the firm may be brought under the control of the debenture holders and preference shareholders.

EBIT-EPS ANALYSIS
It is an analysis to study the impact /effect of the leverage. This could be studied through comparison of various financing plans of EBIT. (i) (ii) (iii) (iv) (v) (vi) (vii) Exclusive use of debt Exclusive use of Equity shares Exclusive use of Preference shares Combination of (i), (ii) & (iii) Combination of (i) & (ii) Combination of (ii) & (iii) Combination of (i) & (iii)

Among the various plans, we have to identify the best plan which has highest EPS over the others.

The firm which has highest EPS normally has least volume of fixed financial charge over the other firms. What is meant by financial break even point ? It is the level of EBIT to meet the fixed financial charge of the firm viz Interest on long term borrowings/Debentures and Preference dividend on Preference shares. The following formula is used to compute the financial break even point for the firm to earn at least to cover the fixed financial charges of the firm: Financial breakeven point= I + PD/1t The next analysis is nothing but Indifference point. Indifference Point: It is the point at which the EPS and EBIT are nothing but the same for two different financing plans known as the indifference point. The indifference point could be found out through the following analyses: (i) (ii) Algebraic approach Graphic approach

The measures of the Financial leverage: They are two in categories: (i) (ii) Stock terms Flow terms

Stock Terms: The following are the two ratios viz debt equity ratio and debt + preference share capital to total capitalization ratio to measure the financial leverage. Flow terms: The financial leverage means debt service ratio and preference dividend coverage ratio to measure the capacity of the firm in meeting the periodical fixed financial commitments of the firm.

COMBINED LEVERAGE
It is the combination of both leverage viz Operating leverage and financial leverage. The combination means that the product of both leverages viz operating risk and financial risk, which facilitates to determine the total risk of the firm.