---
title: "Short note: Capital structure planning"
subject: "Project Engineering"
chapter: 6
key: "semester_7/project_engineering:capital-structure-planning-notes"
source: https://www.bctengineer.com/q/semester_7/project_engineering/capital-structure-planning-notes
site: BCT Engineering
---

# Short note: Capital structure planning

Project Engineering · Chapter 6: Introduction to Project Financing

- Asked in: 2068 Baisakh (old course), 4 marks; 2065 Shrawan (old course), 4 marks (asked 2 times)
- Video: [What is CAPITAL STRUCTURE?  Exploring DEBT & EQUITY in Capital Structure - EDUCATIONLEAVES -2024](https://www.youtube.com/watch?v=tGrAwBdAV80) — The Decode Project
- Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14
- Page: https://www.bctengineer.com/q/semester_7/project_engineering/capital-structure-planning-notes
- Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6

## Question

Write a short note on cash flowability and capital structure / capital structure planning and debt equity ratio.

## Short answer

Cash flowability is the ability to generate cash to meet fixed obligations, measured by interest coverage and debt service coverage; stable cash flow allows more debt. Debt-equity ratio equals long-term debt divided by shareholders' equity, with high leverage giving higher EPS but more risk. The planner selects the ratio minimizing WACC and maximizing EPS with acceptable risk.

## Answer

#### 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.

## Check yourself

The answer's key points as multiple-choice questions, with the correct option and why.

1. How is the interest coverage ratio calculated?
   A. Interest / EBIT
   B. EBIT / interest
   C. EAT / equity
   D. Debt / equity
   Answer: B. Interest coverage = EBIT divided by interest. (Key point: Interest coverage)

2. Why should a firm with uncertain cash flow use more equity?
   A. Equity is always cheaper
   B. Debt is never available
   C. Debt payment is compulsory but dividend is not
   D. Dividends are compulsory
   Answer: C. Interest and instalments must be paid, while dividends can be skipped. (Key point: Uncertain cash flow)

3. What does a high debt-equity ratio mean?
   A. No financial risk and low EPS
   B. Higher cost of capital and lower risk
   C. No debt in the firm
   D. High leverage: cheap funds and higher EPS in good times but higher financial risk
   Answer: D. A high ratio means more leverage and fixed burden. (Key point: Debt-equity ratio)

4. What is the debt-equity ratio?
   A. Long-term debt / shareholders' equity
   B. Equity / long-term debt
   C. EBIT / debt
   D. Total assets / debt
   Answer: A. Debt-equity ratio = long-term debt divided by shareholders' equity. (Key point: Formula)

## Related in Project Engineering

- [Capital structure; cash flowability, leverage ratio](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-structure-cashflowability-leverage) — Project Engineering, chapter 6
- [Capital structure planning concept](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-structure-planning-concept) — Project Engineering, chapter 6, asked 2×
- [Capital structure planning importance, determinants](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-structure-planning-importance-determinants) — Project Engineering, chapter 6

## Related in other subjects

- [Equity versus debt financing with EMI](https://www.bctengineer.com/question.md?key=semester_7%2Fentrepreneurship_development%3Aequity-vs-debt-financing-emi) — Entrepreneurship Development, chapter 6