Algebraic Approach - Indifference Point
Capital Structure represents the way in which a business firm finances its assets. Capital structure is often the source of a business firm's financial growth, the source of financing for its operations, etc. A business firm's capital structure can be a mixture of debt and equity.
Debt:
In this case, debt lies in of long term debt, and finical short term debt. Long term debt is any debt from external sources of finance that require not be compensated in the current fiscal year of 12 months. Short term debt lies in of obligations in the form of 1-year bonds, etc.
Equity:
Equity capital lies in of common shareholders' equity and preferred stock. The common shareholders' equity actually corresponds the fundamental ownership of the firm. When investors purchase shares of the company in the capital market in which the business firm is listed, they become part owners of the firm, based on the number of shares they purchase. This is referred as equity capital or owners equity.
Preferred stock, on the other hand, is when specific investors, like some owners of the company, institutions, and others purchase the shares of the business firm. The preferable stock owners must be compensated dividends before the common stock owners. The another rules for preferred equity is dissimilar in different business firms.
Financial Leverage:
Financial leverage is the evaluation of debt in the capital structure of a firm. A highly leveraged business firm runs a greater risk of building a default in its payments, subsequently it has to pay larger amounts of interests from its earnings. From this comes forth another term, Degree of Financial Leverage (DFL). The Degree of Financial Leverage captures the effect the financial leverage will have on the business firm's earnings. This is in turn pondered in Earnings Per Share.
Indifference Point:
The indifference point is used to ascertain a business firm's optimal capital structure. As seen earlier, business firms prefer for two kinds of financing in terms of long term financing - these are Debt and Equity. When the business firm has equal earnings per share from both the financing options, it is known as an indifference point.
Thus, the algebraic expression for this will be
Earnings Per Share (With Debt) = Earnings Per Share (Without Debt) Or EBIT
Mathematically, the indifference point can be obtained by employing the following symbols:
X = earnings before interest and taxes (EBIT) at the indifference point
N1 = number of equity shares outstanding if only equity shares are issued
N2 = number of equity shares outstanding if both debentures and equity shares are issued
N3 = number of equity shares outstanding if both preference and equity shares are issued
N4 = number of equity shares outstanding if both preference shares and debentures are issued
I = the amount of interest on debentures
P = the amount of dividend on preference shares
t = corporate income tax rate
Dt = tax on preference dividend
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