Capital structure and trading on equity

Capital structure is the mix of owners' funds (equity) and borrowed funds (debt) in a business. It is measured as debt ÷ equity, or debt ÷ (debt + equity).

• Debt is cheaper for the firm (interest is tax-deductible), but riskier, because it must be paid whatever happens.
• Equity is riskless for the firm (no fixed payment), but costlier, since shareholders expect a higher return.

The proportion of debt is called financial leverage. More leverage lowers the cost of funds but raises financial risk.

Trading on equity means using more debt to raise the earnings per share (EPS) of the equity shareholders. It works only when the return on investment (RoI) is more than the interest rate on debt.

Example: a firm needs ₹20 lakh, can borrow at 10%, pays tax at 30%, and issues shares of ₹10.

• If EBIT is ₹2.4 lakh (RoI 12%, above 10%): all equity gives EAT ₹1.68 lakh on 2,00,000 shares, an EPS of 0.84. With ₹10 lakh of debt: interest ₹1 lakh, EBT ₹1.4 lakh, EAT ₹98,000 on 1,00,000 shares, an EPS of 0.98. EPS rises: favourable.
• If EBIT is ₹1.6 lakh (RoI 8%, below 10%): all equity gives EPS 0.56; with the same debt, EAT is ₹42,000 on 1,00,000 shares, an EPS of 0.42. EPS falls: trading on equity is unwise.

The optimal capital structure is the mix at which the share price is highest.