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Corporate Accounting and Financial Management · Capital Structure

Designing Capital Structure and Capital Gearing

Updated 11 October 2026 · Fact-checked

Capital gearing is the ratio of fixed-cost capital (debt and preference shares) to equity capital. Trading on equity means using this fixed-cost capital to raise equity returns when the return on capital exceeds its cost. To design capital structure, weigh cost, risk, control, flexibility and cash flows, then pick the mix that maximises value.

Understand Designing Capital Structure and Capital Gearing

Capital structure is the mix of long-term sources a company uses: equity shares, preference shares, debentures and term loans. Designing it means deciding how much of each to use.

Capital gearing describes how much of the capital carries a fixed return. Fixed-cost capital means debt and preference shares. Equity gets a return only when the company chooses and is able to pay. Gearing is the ratio of fixed-cost capital to equity capital.

A company is highly geared when fixed-cost capital is larger than equity. It is low geared when equity is larger than fixed-cost capital. Some textbooks also use a 'normally geared' company where the two are roughly equal. Always state the base you use.

Trading on equity means using borrowed funds or preference capital so that equity holders earn more. If the company earns a higher rate on total capital than the rate it pays on debt, the surplus goes to equity holders and EPS rises. The reverse also holds: if earnings fall below the cost of debt, EPS falls faster. So high gearing raises both return and risk. Interest is also tax-deductible, which makes debt cheaper after tax. Preference dividend is not deductible.

There is no single correct structure. The planner balances cost, risk, control, flexibility and the company's situation. A stable-earning company can carry more debt. A new or volatile company should carry less.

Key rules to remember

Capital gearing ratio
Gearing = (Preference share capital + Debentures + Long-term loans) ÷ Equity shareholders' funds
Equity funds = equity share capital + reserves and surplus. State the definition you use. Some questions use equity share capital only.
Debt-equity ratio
Debt-equity = Long-term debt ÷ Shareholders' funds
Related but narrower measure, since it leaves out preference capital when preference is shown within shareholders' funds.
Trading on equity test
Favourable if ROI (EBIT ÷ capital employed) > interest rate on debt
Compare after tax when asked: ROI × (1 − t) against interest × (1 − t), or compare EPS directly.
Earnings per share
EPS = (EBIT − Interest − Tax − Preference dividend) ÷ Number of equity shares
Use this to show the effect of trading on equity under different financing plans.
Classification of gearing
High gearing: fixed-cost capital > equity. Low gearing: fixed-cost capital < equity
A direct rule for theory and short numerical questions.

How to solve Designing Capital Structure and Capital Gearing questions

Use the same route for gearing numericals, trading on equity comparisons and theory questions on planning capital structure.

  1. 1Read the question and identify what is asked: gearing ratio, EPS comparison, advantages and disadvantages, or factors.
  2. 2List the capital items. Separate equity (share capital plus reserves) from fixed-cost capital (preference shares, debentures, loans).
  3. 3Compute the gearing ratio and state whether the company is high or low geared.
  4. 4For trading on equity, compute EBIT, subtract interest, then tax, then preference dividend, and divide by the number of equity shares to get EPS under each plan.
  5. 5Compare the return on capital with the cost of debt and say whether trading on equity is favourable.
  6. 6For theory, group your points under cost, risk, control, flexibility, cash flow and market conditions, and link each to the company's situation.
  7. 7Close with a clear conclusion: which structure suits the company and why.

Quickest way: Two-line gearing and EPS check

When to use it: Use when time is short and the question asks you to classify gearing or judge whether debt helps equity holders.

  1. Add up preference capital and debt. Compare this total with equity funds. Larger means high gearing, smaller means low gearing.
  2. Compare ROI with the interest rate. If ROI is higher, debt raises EPS. If lower, it reduces EPS.
  3. If a full EPS table is needed, work down from EBIT to earnings for equity once per plan, then divide by shares.
  4. Write the conclusion in one sentence, naming the plan with higher EPS and the added risk.

Common mistakes in Designing Capital Structure and Capital Gearing

  • Treating high gearing as meaning high equity.

    The word 'gearing' sounds like strength, so students link it to equity.

    Fix: Remember that gearing measures fixed-cost capital against equity. High gearing means heavy debt and preference capital.

  • Leaving preference capital out of fixed-cost capital.

    Students confuse gearing with the debt-equity ratio.

    Fix: Include preference shares in the numerator for capital gearing, unless the question defines it differently.

  • Ignoring tax when comparing EPS.

    Students stop at EBIT minus interest.

    Fix: Deduct tax on profit after interest, then deduct preference dividend, since it is paid from after-tax profit.

  • Saying trading on equity is always beneficial.

    Students learn only the advantage case.

    Fix: State that it helps only when ROI exceeds the cost of fixed-cost capital. Otherwise it reduces EPS and raises risk.

  • Listing factors without linking them to the company.

    Students memorise a bare list.

    Fix: Add one line per factor, such as 'stable sales allow more debt' or 'founders wanting control prefer debt over new equity'.

Worked examples

Example 1

Ananya Textiles Ltd has equity share capital of ₹40,00,000, reserves of ₹10,00,000, 10% preference share capital of ₹20,00,000 and 12% debentures of ₹30,00,000. Calculate the capital gearing ratio and state whether the company is highly or low geared.

Show the solution
  1. Equity funds = ₹40,00,000 + ₹10,00,000 = ₹50,00,000.
  2. Fixed-cost capital = ₹20,00,000 + ₹30,00,000 = ₹50,00,000.
  3. Gearing = ₹50,00,000 ÷ ₹50,00,000 = 1.
  4. Fixed-cost capital equals equity funds, so the company is neither high nor low geared. It is evenly geared.

Answer: The gearing ratio is 1:1 (1.00). Fixed-cost capital equals equity funds, so the company is evenly geared, on the border between high and low gearing.

Example 2

Bharat Foods Ltd needs ₹10,00,000. EBIT is expected to be ₹2,00,000. Plan A: issue 10,000 equity shares of ₹100 each. Plan B: issue 5,000 equity shares of ₹100 each and ₹5,00,000 of 10% debentures. Tax rate is 25%. Compute EPS under each plan and comment on trading on equity.

Show the solution
  1. Plan A: interest is nil. EBT = ₹2,00,000. Tax at 25% = ₹50,000. Earnings for equity = ₹1,50,000.
  2. Plan A EPS = ₹1,50,000 ÷ 10,000 = ₹15.
  3. Plan B: interest = 10% of ₹5,00,000 = ₹50,000. EBT = ₹2,00,000 − ₹50,000 = ₹1,50,000.
  4. Tax at 25% = ₹37,500. Earnings for equity = ₹1,12,500.
  5. Plan B EPS = ₹1,12,500 ÷ 5,000 = ₹22.50.
  6. ROI = ₹2,00,000 ÷ ₹10,00,000 = 20%, which is above the 10% interest rate. So trading on equity is favourable.

Answer: EPS under Plan A is ₹15 and under Plan B is ₹22.50. Plan B gives higher EPS because the 20% return on capital exceeds the 10% cost of debt. The gain comes with higher financial risk, since interest must be paid even if EBIT falls.

Exam tips

  • For a theory question on designing capital structure, write the factors under clear sub-points and add a short company-based reason for each.
  • In numericals, show the full EPS table from EBIT to earnings for equity. Marks are given for each step.
  • State the definition of gearing you use before computing the ratio.
  • Always end a trading on equity answer with the risk side: fixed interest and dividend obligations in poor years.
  • Name the advantages and disadvantages in pairs so the answer looks balanced.

Practice questions from Capital Structure

Designing Capital Structure and Capital Gearing in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Designing Capital Structure and Capital Gearing: frequently asked questions

What is the meaning of high and low capital gearing?

A company is highly geared when its fixed-cost capital (debt and preference shares) is larger than its equity. It is low geared when equity is larger. High gearing means higher possible returns to equity holders but also higher financial risk.

What are the advantages and disadvantages of trading on equity?

Advantages: higher EPS when ROI exceeds the cost of debt, tax saving on interest, and no dilution of control. Disadvantages: fixed payment burden, greater risk in low-profit years, and lower ability to borrow further.

What factors determine the capital structure of a company?

Main factors are cost of each source, risk, control, flexibility, stability of earnings, size and age of the company, capital market conditions, tax position and legal restrictions. Link each factor to the company's circumstances in your answer.

Is capital gearing the same as the debt-equity ratio?

They are close but not identical. Capital gearing includes preference capital with debt as fixed-cost capital. The debt-equity ratio focuses on debt against shareholders' funds. Use the definition given in the question.