2. Definition
“ Capital structure of a company refers to the
composition of its capitalisation and it includes
all long term capital sources i.e., loans,
reserves, shares and bonds”. –gerestenbeg
“ the Capital structure of business can be
measured by the ratio of various kinds of
permanent loan and equity capital to total
capital”. - Schwarty
3. Factors affecting capital structure
INTERNAL
Financial leverage
Risk
Growth and stability
Retaining control
Cost of capital
Cash flows
Flexibility
Purpose of finance
Asset structure
EXTERNAL
Size of the company
Nature of the industry
Investors
Cost of inflation
Legal requirements
Period of finance
Level of interest rate
Level of business activity
Availability of funds
Taxation policy
Level of stock prices
4. Optimal capital structure
The OCM can be defined as “ that capital structure or combination
of debt and equity that leads to the maximum value of the
firm”
OCM maximises the value of the company and hence the wealth
of its owners and minimise the company’s cost of capital.
the following consideration should be kept in mind while
maximising the value of the firm in achieving the goal of the
optimal capital structure:
1. If ROI > the fixed cost of funds, the company should prefer to
raise the funds having a fixed cost, such as, debentures,
Loans and PSC. It will increase EPS and MV of the firm.
2. If debt is used as a source of finance, the firm saves a
considerable amount in payment of tax as interest is allowed
as a deductible expense in computation of tax.
3. It should also avoid undue financial risk attached with the use
of increased debt financing
4. The Capital structure should be flexible.
5. Point of indifference / Range of earnings
The earnings per share, ‘equivalent point’ or ‘point of
indifference’ refers to that EBIT, level at which EPS
remains the same irrespective of Different alternatives of
Debt-Equity mix. At this level of EBIT, the rate of return on
capital employed is equal to the cost of debt and this is
also known as the break-even level of EBIT for alternative
financial plans
Capital Gearing
CG means the ratio between the various types of securities
in the capital structure of the company. A company is said
to e high-gear when it has proportionately higher/larger
issue of Debt and PS for raising the LT resources.
Whereas low-gear stands for a proportionately large issue
of equity shares.
6. Leverage
Leverage-an Increased means of accomplishing some
purpose
In financial management, it is the firms ability to use
fixed cost assets or funds to increase the returns to
its owners;
Financial leverage- the use of long term fixed income
bearing debt and preference share capital along
with the equity share capital is called financial
leverage or trading on equity
A Firm is known to have a favourable leverage if its
earnings are more than what debt would cost. On
the contrary, if it does not earn as much as the debt
costs then it will be known as an unfavourable
leverage.
7. Impact of financial leverage
When the d/f b/w the earnings from assets financed by
fixed cost funds and cost of these funds are
distributed to the equity stockholders, they will get
additional earnings without increasing their own
investment. Consequently, the EPS and the Rate of
return on ESC will go up.
On the contrary, if the firm acquires fixed cost funds at
a higher cost than the earnings from those assets
then the EPS and return on equity capital will
decrease.
8. Significance of financial leverage
Planning of capital structure
Profit planning
Limitations of FL/ trading on equity
Double-edged weapon
Beneficial only to companies having stability
in earnings
Increases risk and rate of interest
Restriction from financial instruments
9. Operating leverage
Operating leverage results from the presence of fixed
costs the help in magnifying net operating income
fluctuations flowing from small variations in revenue.
The changes in sales are related to changes in the
revenue. The fixed costs do not change with the
changes in sales, any increase in sales, FC
remaining the same, will magnify operating revenue
OL shows the ability of a firm to use fixed operating
cost to increase the effect of change in sales and
the charges in fixed operating income.
10. Combined leverage
The OL affects the income which is the result
of production. On the other hand, FL is the
result of financial decisions. The CL focuses
attention on the entire income of the concern
This leverage shows the relationship between
a change in sales and the corresponding
variation in taxable income.
Working capital leverage
This leverage measures the sensitivity of ROI
of changes in the level of current assets.
