CA Intermediate · Financial Management and Strategic Management
Financing Decisions - Capital Structure: CA Intermediate FM Study Guide
Capital structure is the mix of debt, preference and equity a firm uses to fund itself. To solve questions, compute each component's cost, weight them into WACC, measure risk through leverages, compare plans using EBIT-EPS analysis, and conclude which mix best balances cost, risk and control.
What this chapter covers
This chapter is about how a firm funds its assets and what that choice does to cost, risk and shareholder returns. You study the cost of each source of finance, combine them into a weighted average, and see how fixed costs and fixed financing charges magnify profits and losses.
The chapter has two sides. One is theory: Net Income, Net Operating Income, Traditional and Modigliani-Miller views on whether capital structure changes firm value. The other is numerical: cost of debt, preference and equity, WACC, the three leverages, and the EBIT-EPS indifference point. Numerical parts are where most step marks are earned.
It connects directly to the rest of Paper 6 Section A. WACC is the discount rate used in capital budgeting, so errors here carry into investment decisions. Leverages link to cost-volume-profit ideas from costing, and the planning topic links to dividend and working capital decisions. The chapter also helps in Strategic Management answers on financial strategy.
This chapter mixes easy formula-based numericals with MCQ-friendly concepts, so effort converts to marks quickly. Cost of capital, WACC and leverages are standard and repeatable, and the formulas are short. Both MCQs (30 marks across the paper, no negative marking) and written questions can draw on it. It also feeds capital budgeting, so mastering it helps you in the next chapter too.
Financing Decisions - Capital Structure: topics in the order to study them
- 1Capital Structure TheoriesStart with the logic of why the mix of debt and equity matters, so the later formulas have a purpose.
- 2Cost of Capital ComponentsYou need the cost of each source before you can combine them.
- 3Weighted Average Cost of Capital (WACC)It builds directly on component costs and introduces book value and market value weights.
- 4Leverages: Operating, Financial and CombinedLeverages show how financing choices change risk and need EBIT, interest and contribution, which you now handle comfortably.
- 5EBIT-EPS Analysis and Indifference PointIt applies financial leverage to compare financing plans, so learn it after leverages.
- 6Capital Structure Planning and DeterminantsFinish with the qualitative factors, which tie the numbers into a decision and suit theory answers.
How to prepare Financing Decisions - Capital Structure
Treat this chapter as formulas plus short reasoning. Practise numericals in a fixed format and keep theory to crisp points.
- Read the theories once and write a one-line summary of each, noting what it says about value and WACC as debt rises.
- Learn the cost formulas for debt (before and after tax), preference, equity and retained earnings. Note which ones adjust for tax and which do not.
- Solve WACC problems with both book value and market value weights. Always set out a table of source, amount, weight, cost and weighted cost.
- Practise the three leverages from a statement running from sales to EPS. Compute DOL, DFL and DCL and check that DCL = DOL × DFL.
- Solve EBIT-EPS problems by writing EPS for each plan, equating them and solving for EBIT. Verify by substituting back.
- Prepare short point-wise answers on determinants of capital structure and attempt MCQs to test concepts and quick calculations.
Common mistakes in Financing Decisions - Capital Structure
Applying the tax adjustment to preference or equity cost.
Fix: Adjust only interest on debt. Preference dividend and equity returns are paid after tax.
Using the wrong weights in WACC.
Fix: Read which basis is asked. Use the same basis for every source and show the weight table.
Mixing up the leverage formulas.
Fix: Link each to its risk: operating leverage uses fixed operating costs, financial leverage uses fixed financing charges. Build the statement from sales down to EPS first.
Forgetting preference dividend or tax in EPS calculations.
Fix: Follow the full chain: EBIT, less interest, less tax, less preference dividend, then divide by equity shares.
Solving the indifference point without a final check.
Fix: Substitute your EBIT into both EPS expressions and confirm they match.
Writing long, generic answers on theories and determinants.
Fix: Give short headed points with one line of explanation each, and end with a conclusion where the question asks for one.
Last-day revision: Financing Decisions - Capital Structure
- Capital structure is the mix of long-term debt, preference and equity.
- Cost of debt after tax = Interest rate × (1 − tax rate).
- Cost of preference and equity are not tax-adjusted, since dividends are paid from post-tax profit.
- WACC = Σ (weight × cost of each source).
- Market value weights reflect current conditions; book value weights are easier to compute.
- DOL = Contribution ÷ EBIT.
- DFL = EBIT ÷ (EBIT − Interest), and with preference dividend the denominator also subtracts the grossed-up preference dividend.
- DCL = DOL × DFL. When there is no preference dividend, DCL = Contribution ÷ (EBIT − Interest). Otherwise subtract the grossed-up preference dividend too: DCL = Contribution ÷ [EBIT − Interest − Pref. Div ÷ (1 − t)].
- Indifference point is the EBIT at which two financing plans give the same EPS.
- Above the indifference EBIT, the plan with higher financial leverage (more debt or preference) gives higher EPS; below it, the plan with lower financial leverage (more equity) gives higher EPS.
- Under the NOI approach and MM without taxes, value does not depend on capital structure.
Financing Decisions - Capital Structure practice questions
- Which statement about the Net Operating Income (NOI) approach to capital structure is correct?
- Meera Ltd has EBIT of ₹8,00,000 and 12% debentures of ₹20,00,000 outstanding. It has 1,00,000 equity shares. Using the EBIT-EPS approach and…
- Sharma Textiles Ltd has EBIT of ₹12,00,000. It has 10% debentures of ₹40,00,000 and 1,00,000 equity shares of ₹10 each. The tax rate is 25%.…
- Ganga Steels Ltd has an unlevered cost of equity of 12%, pre-tax cost of debt of 8% and a tax rate of 25%. Its target capital structure has …
- According to the Modigliani-Miller (MM) hypothesis without taxes, the value of a levered firm is:
- Sundaram Ltd has EBIT of Rs 12,00,000. It has Rs 40,00,000 of 10% debentures outstanding. Its equity shareholders require 15% return. Using …
- Which of the following best describes the 'pecking order' approach to financing?
- According to the Modigliani-Miller (MM) proposition without taxes, which of the following statements about a firm's value is correct?
Financing Decisions - Capital Structure in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Financing Decisions - Capital Structure: frequently asked questions
Is this chapter mostly theory or numericals?
It is a mix, but numericals dominate. Cost of capital, WACC, leverages and EBIT-EPS are calculation topics, while theories and determinants are short theory answers.
Do I need to memorise all capital structure theories in detail?
You need the core idea of each and its view on value and cost of capital as debt changes. That is enough for MCQs and short written answers.
How do leverages connect to EBIT-EPS analysis?
EBIT-EPS analysis applies financial leverage. It shows how EPS changes with EBIT under different debt levels, and the indifference point marks where the best plan switches.
Can MCQs from this chapter be solved quickly?
Yes. Many are one-step formula questions on after-tax cost of debt, DOL, DFL or WACC. Practise them without a calculator where numbers are simple, and attempt every one since there is no negative marking.