Capital structure: meaning, factors, leverage and EBIT–EPS analysis

Financial Management · Unit II · Topic 6 of 16 · 5 min read

Capital structure, financial structure and capitalisation distinguished, the features of an optimum structure, the factors that determine capital structure (asked in January 2026 and February 2025), operating, financial and combined leverage (DOL 1.6, DFL 1.25, DCL 2.0) checked against a 10% rise in sales, trading on equity, and an EBIT–EPS indifference point of Rs. 1,00,000 worked out.

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On this page

1. Meaning
2. Features of an optimum (sound) capital structure
3. Factors determining capital structure
4. Leverage: operating, financial and combined
5. EBIT EPS analysis
How this is examined

Cases checked to exist. Read the judgment before quoting a holding.

Every case cited here has been checked to exist — the citation resolves and names the right parties. The propositions attributed to each case have not been verified line by line against the judgment. Case names link through to the full judgment: read it before quoting a holding in an examination answer, and never carry a proposition from notes into court on trust.

The examinable core. “Explain the various factors which influence the capital structure of a company” was the 10-mark Unit II essay in January 2026, and “Define capital structure. Explain the factors determining capital structure” the 6-mark note in February 2025. Learn the list in section 3 under short headings; support it with the leverage figures in section 4.

1. Meaning

Capital structure is the mix of long-term sources of funds: equity share capital, reserves and surplus (retained earnings), preference capital, debentures and long-term loans. It is expressed as a ratio, such as debt to equity of 1 : 1. Financial structure is wider: it includes current liabilities, that is, the whole liabilities side of the balance sheet. Capitalisation is the total amount of long-term funds; a firm may be over- or under-capitalised.

2. Features of an optimum (sound) capital structure

Profitability: it keeps the overall cost of capital low and earnings per share high.
Solvency: debt is kept within the firm’s ability to pay interest and repay.
Flexibility: it can be expanded or contracted as needs change.
Control: it does not dilute the control of the existing shareholders.
Conservatism and simplicity: few classes of securities, within legal limits.

3. Factors determining capital structure

Trading on equity: if the return on investment exceeds the interest rate, debt raises EPS (section 4).
Stability of earnings and cash flow: a firm with steady earnings (utilities) can carry more debt; one with fluctuating sales should rely on equity.
Cost of capital: debt is cheapest after tax, then preference, then equity.
Tax: interest is deductible, dividends are not; a higher tax rate favours debt.
Control: new equity dilutes voting control; debt and preference shares do not.
Risk: more debt means more financial risk and a higher chance of insolvency; business risk of the industry matters too.
Flexibility and timing: keeping debt capacity in reserve; issuing equity when share prices are high and debt when interest rates are low.
Nature and size of the business: small firms find equity harder to raise; asset-heavy firms can offer security for loans.
Legal requirements: the Companies Act, 2013 (for example, limits on borrowing by the board under section 180(1)(c) without a special resolution, and conditions for issue of debentures under section 71), SEBI regulations on public issues, and RBI rules for borrowing abroad.
Market conditions and investors’ attitudes, lenders’ conditions (covenants), and the flotation cost of each source.
Industry norms and the purpose of finance: productive projects can be debt-financed; others need equity.

4. Leverage: operating, financial and combined

Leverage is the magnifying effect of fixed charges: because some costs do not change with sales, a given percentage change in sales produces a larger percentage change in profit. British texts call it gearing.

Operating leverage arises from fixed operating costs (rent, salaries, depreciation). Degree of operating leverage (DOL) = Contribution ÷ EBIT = % change in EBIT ÷ % change in sales. It measures business risk.
Financial leverage arises from fixed financial charges (interest, and preference dividend). Degree of financial leverage (DFL) = EBIT ÷ EBT = % change in EPS ÷ % change in EBIT. It measures financial risk. Financial leverage is also called gearing or trading on equity: using fixed-cost funds to raise the return to equity shareholders, which works only while the return on investment exceeds the cost of debt.
Combined (composite) leverage: DCL = DOL × DFL = Contribution ÷ EBT = % change in EPS ÷ % change in sales. It measures total risk.

Where preference dividend (D_p) is paid, DFL = EBIT ÷ [EBT − D_p ÷ (1 − t)].

Worked example. Sales Rs. 10,00,000; variable cost 60% of sales; fixed cost Rs. 1,50,000; interest Rs. 50,000; tax 40%; 50,000 equity shares. The second column tests the answer with a 10% rise in sales.

Particulars	Present Rs.	Sales +10% Rs.
Sales	10,00,000	11,00,000
Less variable cost (60%)	6,00,000	6,60,000
Contribution	4,00,000	4,40,000
Less fixed cost	1,50,000	1,50,000
EBIT	2,50,000	2,90,000
Less interest	50,000	50,000
EBT	2,00,000	2,40,000
Less tax 40%	80,000	96,000
PAT	1,20,000	1,44,000
EPS (50,000 shares)	2.40	2.88

DOL = 4,00,000 ÷ 2,50,000 = 1.6; DFL = 2,50,000 ÷ 2,00,000 = 1.25; DCL = 4,00,000 ÷ 2,00,000 = 2.0 (= 1.6 × 1.25). Check: sales rise 10%; EBIT rises 40,000 ÷ 2,50,000 = 16% (10% × 1.6); EPS rises 0.48 ÷ 2.40 = 20% (16% × 1.25, or 10% × 2.0). The same multipliers work in reverse: a 10% fall in sales cuts EPS by 20%.

A firm with high operating leverage should keep financial leverage low, and the reverse, so that combined leverage (total risk) stays manageable.

5. EBIT–EPS analysis

A firm needs Rs. 10,00,000. Plan A: all equity, 1,00,000 shares of Rs. 10. Plan B: Rs. 5,00,000 equity (50,000 shares) and Rs. 5,00,000 of 10% debentures. Tax 40%. Expected EBIT Rs. 2,00,000.

Particulars	Plan A	Plan B
EBIT	2,00,000	2,00,000
Less interest	—	50,000
EBT	2,00,000	1,50,000
Less tax 40%	80,000	60,000
PAT	1,20,000	90,000
Shares	1,00,000	50,000
EPS	1.20	1.80

Indifference point: (X)(0.6) ÷ 1,00,000 = (X − 50,000)(0.6) ÷ 50,000, so X = 2(X − 50,000) and X = Rs. 1,00,000. At that EBIT both plans give EPS Rs. 0.60. Above it the debt plan gives the higher EPS; below it, equity is better.

Trap. A higher EPS is not automatically a higher share price. Debt raises EPS only while EBIT is above the indifference point, and it raises risk all the time; that is why the factors in section 3, not EPS alone, decide the structure.

How this is examined

For the 10-mark essay (January 2026), write the meaning and features in a few lines, then eight to ten factors from section 3 with a sentence each, and close with the leverage example to show trading on equity. For the 6-mark note (February 2025), give the definition and six factors. The recent papers set no leverage numerical, but knowing DOL, DFL and DCL strengthens the MM and capital structure answers.

Now try the real questions: Financial Management past question papers.