Short note: Capital structure planning

Cash flowability and capital structure

Cash flowability is the ability of a firm to generate enough cash from operations to meet fixed obligations such as interest and loan instalment. It is measured by the interest coverage ratio (EBIT / interest) and the debt service coverage ratio. If cash flow is stable and strong (for example a hydropower plant with a long-term power purchase agreement), a firm can use more debt in its capital structure. If cash flow is uncertain, more equity should be used, because debt payment is compulsory but dividend is not.

Capital structure planning and debt-equity ratio

Capital structure is the mix of long-term sources of funds (equity shares, preference shares, retained earnings and long-term debt) used by a firm to finance its total capital. Capital structure planning is the process of deciding the best proportion of these sources so that the cost of capital is lowest and the value of the firm and return to shareholders are highest.

The debt-equity ratio is

$$\text{Debt-equity ratio} = \frac{\text{Long-term debt}}{\text{Shareholders' equity}}$$

• A high ratio means high leverage: cheap funds and higher EPS in good times, but high financial risk and a fixed burden.
• A low ratio means low risk but higher cost of capital and lower EPS.
• Infrastructure projects normally use 70:30 or 75:25 debt-equity, while lenders and regulators may set the limit.
• The planner selects the ratio that gives the lowest weighted average cost of capital and the highest EPS with acceptable risk.